You'd think that paying off a car loan early would always be a good thing. But you should also know potential disadvantages of paying off a car loan early before you write that check.
Own Your Car Free and Clear
Paying off a car loan early sounds like a great financial strategy. It's usually a big monthly cost, and once that loan is gone you'll have a lot of cash more each month. But driver beware; auto financing often involves a quirky form of counting that can make prepayments surprisingly expensive. It turns out there can be a penalty for paying off a car loan early.
Auto financing is huge. At the end of 2019, vehicle loans worth $1.33 trillion were outstanding according to the Federal Reserve Bank of New York. That's up from $720 billion ten years earlier, a huge increase.
A car, pick-up, or van is a practical necessity in virtually all communities, and vehicle buyers pay the price for transportation. In the third quarter, according to Experian, the average new car loan was $32,480. And the typical used car buyer financed with a $20,446 loan.
Loans today are typically more than five years in length. Experian figures show that the typical new car payment is $550 a month for new vehicles versus $393 for used cars and trucks.
How Can Paying Off a Car Loan Early Hurt Your Credit?
In some cases paying off a car loan can hurt your credit. Sounds strange but it does happen. Experian - one of the three big credit reporting agencies - explains it this way:
"Whenever you make a major change to your credit history - including paying off a loan - your credit score may drop slightly. If you don't have any negative issues in your credit history, this drop should be temporary; your credit scores will rise again in a few months. After it's paid off and the account is closed, your car loan will remain on your credit report for up to 10 years, and as long as you always made your payments on time, the loan will continue to have a positive effect on your credit history.
"So what's the problem with paying off your car loan early? Even though closed accounts still affect your credit score, open positive credit accounts have more of an impact than closed ones. That's because open accounts show lenders how well you're managing your credit right now - not in the past."
When Should You Keep Your Car Loan?
Auto loans come in two general flavors. There is simple-interest auto financing and rule-of-the-78s financing.
You pay interest based on the outstanding monthly loan balance with a simple-interest loan. There's no penalty for prepayment. CarMax, as one example, offers simple-interest auto financing for the used vehicles it sells.
Many dealers, however, use financing based on the rule of 78s, also known as the sum-of-the-digits method. If the loan is not based on simple interest, you're likely to find financing terms that move some of the interest to the front of the loan. The result is that prepaying the loan arranged with the rule of 78s is less attractive than prepaying a loan with simple interest.
Here's an example that compares a simple loan with rule-of-78s financing. Notice that the total interest cost with both loans is the same - but WHEN the costs must be paid are different.
Simple Interest Versus Rule-of-78s Auto financing
|Loan Type||Simple Interest||Rule of 78s|
|Loan term||60 months||60 months|
|Interest Cost, Year 1||$1,486||$1,535|
|Interest Cost, Year 2||$1,308||$1,318|
|Interest Cost, Year 3||$964||$945|
|Interest Cost, Year 4||$600||$574|
|Interest Cost, Year 5||$216||$202|
|Numbers rounded. Rule-of-78s-calculator from: https://financial-calculators.com/amortization-schedule|
You Have Promotional Financing
Auto dealers frequently offer promotional financing. You might see offers of "0%" financing.
You have to read these offers carefully. The Consumer Financial Protection Bureau explains them this way.
"A zero percent interest promotion will not add interest based on the balance of your promotional purchase during the promotional period. Even if you still have an unpaid balance when the promotional period is over, you will start to pay interest on that remaining balance only from the date the promotional period ends. This promotion may also require you to meet other terms as well, such as making your minimum monthly payments on time. You may see a phrase like, '0% intro APR for 12 months,' to describe this type of promotion.
"In contrast, you might have seen retailers offering credit cards with advertisements like, 'No interest if paid in full in 12 months.' Watch out for the 'if.' That means the promotion is a deferred interest offer. Deferred interest means that if you do not pay off the entire balance of the promotional purchase you've made on your card, then interest going back to the date of the purchase will be added on top of the remaining balance. This promotion may also require you to meet other terms as well, such as making your minimum monthly payments on time." (Emphasis theirs)
If you really do pay zero interest, don't worry about the lender. With such financing, you likely will find that other promotions are unavailable and a higher vehicle price covers any lost interest.
Paying Off Your Car Loan Early Would Wipe Out Your Savings
Nope. Not a good strategy. You always need cash reserves because you never know when a financial emergency will arise. Personal finance experts recommend that you keep enough ready cash to cover at least two months of expenses if you're a wage-earner, and up to six months of expenses if you are self employed or work on commission.
Your Car Loan Is Almost Paid Off
In some cases - but not all - mortgage lenders will not count monthly auto payments against you when computing a debt-to-income (DTI) ratio if 10 or fewer payments remain. Credit scores may be impacted in two ways. Less debt is good and should help raise scores. However, as above, Experian points out that "open positive credit accounts have more of an impact than closed ones. That's because open accounts show lenders how well you're managing your credit right now - not in the past."
When Should You Pay Off Your Car Loan Early?
You should only pay off an auto loan when it's to your advantage. If you can reduce monthly costs or lower interest expenses, prepaying a car loan can be an attractive financial strategy - but only if you retain solid cash reserves for emergencies. If you have deferred interest financing refinancing may allow you to qualify for zero interest. A caution. If you replace a current auto loan with a new and longer loan, the total interest cost may be higher. Even with a lower rate and smaller monthly payment. Always run the numbers.
Your Auto Loan Interest Rate Is High
If your auto loan interest rate is high, you may want to consider refinancing with a personal loan at a lower rate. Be aware of total loan costs - interest plus up-front fees and charges - when considering replacement financing.
Your Car Payments Are Too High
Big monthly car payments can be a financial problem (the monthly cost is uncomfortable) and a financial one (big payments can impact the debt-to-income (DTI) calculations when you apply for a mortgage). If monthly costs are too high, consider a personal loan to refinance the existing loan balance.
Should You Refinance Your Car Loan?
Please note that refinancing your car loan may solve some of the above problems. If your payments are too high for comfort or your DTI is too high for a mortgage, stretching out the payments over a new term, especially if you can get a lower rate, can help. If paying off the loan would wipe out savings, consider paying it down and refinancing the balance. You lower the payment and also keep some emergency savings.