by Andrew Rohrlich
Paying off a car loan early can be a smart financial decision. Long-term loans can be expensive and come with high interest rates, so paying off your car loan faster allows you to save money on interest payments.
But you may wonder: Is it good to pay off a car loan early? Let's take a look at some reasons why you might want to pay off a car loan early, and five easy ways you can do so.
Why You Might Want To Pay Off Your Car Loan Debt
If you are seeking to lower payments on your auto loan, early payoff may offer enticing benefits that make it worth it for you.
We all want to save money, and paying off your car loan debt early can help you do just that. When you pay your monthly auto loan payment, you pay two costs:
- Principal: The original amount of money borrowed
- Interest: The cost the lender charges to let you borrow
For example, if you take out a $10,000 loan with a 60-month repayment term and a 5% interest rate, you'll pay $11,322.74 — the $10,000 principal and the $1,322.74 interest cost. But if you pay the loan off in four years instead of five, you'd only pay about $1,055 in interest, which saves you about $268 over the life of the loan.
These savings only apply for simple interest loans, since the lender bases the interest on what you owe at the given time. It's always best to pay attention to the type of loan you're getting before you finance your car.
Improved Credit Score
You can improve your credit score by making payments in full on time. As you build a credit history of on-time payments, you may notice your credit score increase.
Paying off and closing the car loan account doesn't harm your credit score, especially if you add other open accounts to your credit while you pay on your car loan.
Sometimes, your score falls by a few points right after you pay off a car loan early, so it may be better to wait if you need to maintain your score for other purchases. However, it will usually improve over time. Early loan payoff can improve your credit utilization ratio — the percentage of your total credit limit that you use. The less money you owe, the lower your credit utilization rate will be. It also lowers your debt-to-income ratio — how much debt you owe compared to your income.
Lenders look at these factors to determine if you're a responsible borrower. The lower these two figures are, the higher your credit score will be. And the higher your credit score, the more opportunities you have to use your credit to fund other important purchases, such as a home mortgage.
Better Car Insurance Rates
Paying off your car loan early can also open up access to better car insurance rates. Since leasing companies own the car in full until you pay it off, most require you to purchase and maintain full coverage car insurance to protect their loan. Full coverage car insurance can include:
- Comprehensive coverage: pays for non-collision damage to your vehicle, including theft, fire, glass and windshield damage, vandalism, and accidents with the weather, animals, or other acts of nature.
- Collision coverage: pays for collision damage to your vehicle, including damage caused by other cars or objects such as telephone poles, potholes, or mailboxes.
- Any other state-required coverage: most often includes liability coverage, which protects you if you are legally responsible for property damage or injuries in a car accident.
Full coverage insurance can be costly, depending on the vehicle type and your driving record. Once you pay off your car loan, however, you own the car fully and do not have to get comprehensive coverage insurance on it.
4 Tips For a Faster Payoff
If you've decided to pay off your car loan early, there are several ways to do so. The following five strategies are among the most effective.
1. Consider Refinancing
One of the most common ways to pay off a car loan faster is to refinance. Put simply, refinancing is when you replace your current loan with a new one. The new lender will pay off your existing loan, and you will only make payments on the new loan.
Refinancing your car usually gives you a lower interest rate, which can lower your monthly payments and save you money long-term. Lowered interest rates can amount to hundreds or thousands of dollars in savings, especially when combined with a shorter loan term.
However, it is important to note that your credit score may drop temporarily when you refinance a car.
2. Round Up to the Nearest 50 or 100
Making larger payments by rounding up to the nearest $50 or even $100 can help you pay off your car loan more quickly.
For example, if you borrowed $7,500 at a 5% interest rate for 72 months, your monthly loan payments would be about $105. You would pay about $1,037 in interest over the life of your loan. But if you round the payment up to $150, you can pay the loan off at least a year early and save almost $200 in interest.
3. Use Your Tax Refund
Your tax refund gives you a lump sum of cash that you can use to reduce your current car loan balance. You can do so by making extra payments or even paying off the entire debt in full. This will greatly lower the amount of interest you pay, which can save several hundred or even thousands of dollars.
4. Make Biweekly Payments Instead of Monthly Payments
Making biweekly payments instead of monthly payments can help you pay off your loan earlier. When you pay monthly, you make 12 payments per year. But if you split your monthly bill in half and pay one half every two weeks, you end up making the equivalent of 13 monthly payments in one year.
For example, say that you have to pay off $10,000, and your monthly payment comes to $200 with all fees added in. If you paid monthly, you would pay a total of $2,400 a year. So, you would pay your loan off in a little over four years.
If you paid $100 biweekly, however, you would pay a total of $2,600 a year. This means you can pay your loan off in less than four years if it fits your budget.
Beware of Prepayment Penalties
Though paying off your car loan early does have many benefits, there are also several potentially negative factors to be aware of — one of which is prepayment penalties.
A prepayment penalty is a fee that the lender charges you if you pay off your loan early. Your loan terms include this fee, so it's best to read them carefully.
If your loan does have an early payoff penalty, you'll need to consider if the benefits of paying off the loan early are worth paying the fee.
This article was written by Andrew Rohrlich. As a brand and product marketing expert, Andrew Rohrlich has crafted products, experiences and communications for household names like Gap and for multiple automotive technology businesses. For nearly a decade Andrew has studied automotive retail in depth from a customer point of view and aggregated the industry’s best research, thought leadership and know how to provide credible and important information to auto shoppers and sellers.