Popular wisdom says anytime you can pay off a debt early you should do so. However, there are some instances in which you shouldn’t end a car loan early. Let’s take a look at some of the arguments for doing so and some key reasons against it.
For: Keeps You “Right Side Up” in the Loan
In some cases, if a car loan is allowed to run its full term, you could wind up owing more than the car’s fair market value. Known as being “upside down” in your loan, repaying it before it goes to term will almost always help you avoid this situation. You’ll also have a lot more flexibility should you need to sell the car, or if your insurance company declares it a total loss.
For: Potential Interest Savings
A key benefit of paying off any type of loan early is the reduction of the amount of interest you’ll pay. Interest payments are figured into your outstanding balance each month (in most cases). Thus, the sooner you repay the loan, the fewer interest payments you’ll be required to make. Running your numbers through a car loan calculator will help you see how much you could save by paying your loan off early.
For: Reduces Your Debt Load/Improves Your Monthly Cash Flow
Every month you’re making that car payment is a month that money could be doing something else for you. You could use it to increase your emergency fund, invest for retirement or save for a vacation.
Another advantage of having that debt off the books is it advances your income to debt ratio. The higher your income relative to the financial obligations you have, the more creditworthy lenders will consider you to be.
Additionally, if something comes up and you need a loan to deal with it, having that car loan off your back will give you an edge. Every additional dollar of disposal income is a welcomed asset when you’re expecting a child or need to care for aging parents.
Against: Possible Pre-Payment Penalties
Here’s where that whole “in most cases” caveat we mentioned above comes into play. You’re golden if you have a loan on which you pay interest based upon what you owe at a given time (a simple interest loan). However, you’ll have to pay the full amount of your interest payments if they are pre-computed — even if you repay the loan early. The good news is most car loans are simple interest. However, you should always ask to make sure and have it in writing.
Against: Inhibits Your Ability to Save
Always build the nest egg first if you must choose between paying off your car loan early and putting away cash to create an emergency fund. This way you can minimize the amount of debt you’ll have to take on if something goes awry.
Most financial gurus advise having at least three to six months of living expenses set aside for such occurrences. Once you’ve accomplished this, you might be in better shape to pay off the loan.
Against: Negative Impact on Your Credit Score
One of the factors upon which your credit score is based is your history of on time payments. If you pay off the car loan, it will be closed and will no longer be reflected on your credit report. This could actually make your score drop if you have few other open accounts.
Long story short, if you’re wondering whether you should pay off your car loan early, take a look at your circumstances to see if any of the above considerations apply before you decide.