Pros and Cons of Paying Off Your Car Loan Early

Do you have extra cash? Maybe you got a bonus at work, received a large tax refund, or another unexpected financial windfall. If you have a car loan, it might make sense for you to use that cash to pay off your car loan.

Paying off your car loan will help you save money on interest payments and can improve your chances of getting a mortgage, but it may hurt your credit score in the near term.

Let’s dive in to explore when it is and isn’t a good idea to pay off your car loan early. If you want to jump to a specific section, please use the links below:

• Do you save money and interest paying off the loan early?
• Disadvantages of paying off a car loan
• Advantages of paying off a car loan
• How should I pay off my car loan early?
• Does paying off a car loan hurt my credit?
• Alternatives to paying off the car loan

Do you save money and interest paying off the loan early?

In most cases, paying off a car loan early will save money that would otherwise go toward interest payments — but not if you have a zero percent car loan.

If you have a 0% interest rate, there’s little benefit to paying off your car loan early. You’re better off putting that extra cash toward paying off other high-interest debt or investing the money.

On the other hand, if you have a higher interest rate car loan with several years of payments remaining, paying off the loan could save you a significant amount.

To illustrate, say you originally financed your car with a $20,000, 72-month loan at 10%. You have 48 months remaining and a loan balance of $14,609. Paying off the balance would save you over $3,000 in interest.

Disadvantages of paying off a car loan

Paying off a car loan early can help you save money and enjoy a debt-free life faster, but there are potential drawbacks. Do any of these disadvantages apply to you?

Your money may be better used elsewhere

If you don’t have enough money in your emergency fund to cover six to nine months of expenses, you’re better off putting your money into a high-yield savings account than paying off your car loan.

Without an emergency fund, unforeseen financial setbacks — such as losing your job or facing an expensive car repair — can force you to pull out a higher interest credit to pay for emergencies. Then, any money you saved by paying off your loan goes up in smoke.

You could be penalized

Banks and finance companies sometimes include prepayment penalty clauses in auto loan contracts, which require borrowers who pay off their loans early to pay a fee. Before paying off your auto loan early, check your contract to see whether there’s a penalty for paying early and how they calculate the penalty.

If a prepayment penalty offsets the potential auto loan interest savings, you’re better off using your extra cash for something else.

Advantages of paying off a car loan

Despite the potential downsides, there are many benefits to paying off debt.

You increase your monthly cash flow

Any time you pay off debt, you free up cash in your monthly budget. You can put the amount you would be paying toward your car loan into paying off other debts, saving a down payment for a house, or other financial goals.

You can save money

As long as you don’t have a zero-interest loan and there’s no prepayment penalty, paying off your car loan early allows you to save money on interest. The amount you’ll save depends on your remaining loan balance and interest rate.

To see how much you’ll save by paying off your loan early, plug your loan details into an auto loan payoff calculator, like this one from BankRate.

You may improve your chances of getting approved for a mortgage

Part of the mortgage approval process includes calculating your debt-to-income (DTI) ratio, which compares your monthly debt payments to your monthly income.

According to the CFPB, most lenders require borrowers to have a DTI ratio no greater than 43% to qualify for a mortgage^[1].

For example, say your monthly gross income is $4,000, and you want a mortgage that would cost $1,200 per month. You also have the following debts:

• $300 car payment
• $200 credit card payment
• $100 student loan payment

In that case, your DTI (including the potential mortgage loan payment) would be calculated as:

__($1,200 + $300 + $200 + $100) / $4,000 = 45%__

How should I pay off my car loan early?

Whether you make a lump sum payment or pay a little extra on your monthly payment, paying off a car loan early requires making one or more principal-only payments, and your lender may not make it easy.

Some lenders don’t apply extra payments directly to principal. Instead, they’ll apply it first to any interest accrued since your last payment or treat it as an early payment of next month’s principal and interest.

If you want to pay off your car loan early, don’t simply take the balance due shown on the lender’s website or your most recent statement. Call the lender and tell them you’re interested in paying your loan in full or making a lump-sum principal-only payment.

Find out exactly what you need to do to ensure the payment is applied correctly. Your lender may require you to write an extra check for principal-only payment or mail the payment to a different address. Follow their directions, then call again in a couple of weeks to ensure they applied your payment and your loan is truly paid in full.

Does paying off a car loan hurt my credit?

Getting out of debt is definitely good for your long-term financial health. So, does paying off a car loan help credit?
It may be hard to believe, but paying off a car loan can hurt your credit score — especially if you’re just starting to build credit. (Here’s why having a car loan can build credit.)

Your account will be closed

According to Experian^[2]:

“Once your loan is paid off, the account will be closed. Although closed accounts may show you successfully managed credit in the past, open credit accounts have a greater impact on your credit score because they show lenders how well you’re managing credit in the present.”

Your credit mix will change

According to FICO®, credit mix accounts for approximately 10% of your credit score^[3]. People with a mix of credit cards and an installment loans typically score higher than people with only one type of debt.

If you pay off your car loan and have only one type of account remaining, your credit score could drop.

Your length of credit history will be lower

Length of credit history accounts for around 15% of your FICO credit score and considers the age of your oldest account, among other factors. If your car loan is your oldest account and you pay it off, the account closure could hurt your credit score.

Fortunately, according to Experian^[4], most people only see a minor drop in their credit score, and the change is usually temporary, so don’t let that dissuade you from your goal of getting out of debt.

However, if you’re currently applying for a mortgage and you don’t need to pay off your car loan to qualify, you may want to hold off. That’s when even minor, temporary drops in your credit score can have long-term consequences, so you should wait to pay off your car loan until your mortgage is finalized.

See our related pieces about how refinancing a car loan affects your score and how fast a car loan will affect your credit for more insights.

Alternatives to paying off the car loan

If paying off your car loan isn’t the best use of your cash surplus, consider some other ways that money can come in handy, such as:

• Shoring up your emergency fund. Consider depositing the money into your savings account if you don’t have enough cash to cover six to nine months of expenses. It doesn’t make sense to pay off a low-interest-rate car loan and then take on high-interest credit card debt in the event of a financial emergency.
• Make long-term investments. Retirement accounts and other investments benefit from compound interest, so the sooner you start saving and investing, the better off you’ll be down the road. If you have extra cash, put some or all of it in your IRA, 401(k) or brokerage account.
• Pay off other high-interest debt. Credit card debt tends to come with higher interest rates than car loans. If you’re carrying credit card debt, it’s usually a good idea to prioritize paying that off before paying off a car loan.
• Invest in your career. You may be able to improve your future career prospects by getting a degree or certification or learning a new skill. Consider whether you can put your money to work in a way that will increase your earning potential for years to come.

Being debt-free, or at least free of any monthly car payment, is certainly an excellent position to be in financially. But you should only pay off a car loan early when it works to your advantage.

If you have little or no emergency savings or other high-interest debt, paying off your car may not be your top priority. But if you are otherwise financially stable, run the numbers to make sure paying off your loan is the right financial move.

Article Sources

1. Consumer Financial Protection Bureau. "What is a debt-to-income ratio? Why is the 43% debt-to-income ratio important?" https://www.consumerfinance.gov/ask-cfpb/what-is-a-debt-to-income-ratio-why-is-the-43-debt-to-income-ratio-important-en-1791/ - Accessed May 14, 2021
2. Experian. "Can You Pay More on Your Car Payment?" https://www.experian.com/blogs/ask-experian/can-you-pay-more-on-your-car-payment/ - Accessed May 14, 2021
3. myFICO. "What's in my FICO® Scores?" https://www.myfico.com/credit-education/whats-in-your-credit-score - Accessed May 14, 2021
4. Experian. "Does paying off a car loan early hurt your credit?" https://www.experian.com/blogs/ask-experian/does-paying-off-a-car-loan-early-hurt-your-credit/ - Acccessed May 14, 2021

About the author

Janet Berry-Johnson is a Certified Public Accountant and freelance writer with a background in accounting and insurance. Her writing has appeared in Forbes, Freshbooks, The Penny Hoarder, and several other major outlets. See Janet's profile on Linkedin.

About the reviewer

Lauren Bringle is an Accredited Financial Counselor® with Self Financial – a financial technology company with a mission to increase economic inclusion by helping people build credit and savings. Connect with her on Linkedin or Twitter.