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Does it allow early repayment of the car loan?
by
Irene Scott
January 10, 2023
Verified by
Quinanna Patterson
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The choice to pay off an auto loan early depends on your budget, the interest rate of the loan, and other financial goals.
In general, it is a good idea to pay off your car loan early if you have no other high-interest debts or emergency expenses. But if that money could be better spent elsewhere, paying off your car loan early may not be the best choice.
When does it make sense to pay off an auto loan early?
In some cases, it may make sense to focus your efforts on eliminating car loan debt. Check to see if this applies to you:
- You do not have high interest rate debt and want to free up money for other financial goals.
- The interest rate on the car loan is higher than what you could get by investing.
- You hope to buy a house soon and want to reduce your debt-to-income ratio.
- You have recently received an influx of money and have enough money set aside for emergencies.
- You want to grow your savings account faster so that you have funds for business ideas or other investments that promote financial freedom.
- You want to avoid having negative net worth or being in the red on your car loan.
- You have an aversion to debt and this is an important step in achieving financial security.
Advantages of paying off your car loan early
If you can, prepaying an auto loan can have significant advantages.
Interest saved
Interest is usually spread over the term of the loan. You will pay less interest by paying off the loan early because the lender will have less time to collect interest.
But even an extra payment can make a difference. This extra amount should be applied directly to the principal, especially if it is specified at the time of payment.
Use an auto loan prepayment calculator to find out how much you can save by making extra monthly payments or making a lump sum payment on your loan.
Things to remember: The more money you add to your payments and the larger the loan amount, the more you can save.
Become a homeowner first.
Until you pay off your auto loan, the lender technically owns the vehicle. Owning the vehicle means you get the title in your own name. It also means that you will have more choices if you intend to sell the car or trade it in.
If the lender requires minimal insurance coverage, you may be able to reduce your insurance costs by choosing basic coverage. If you own the car, you may decide to keep the insurance coverage or change its levels. But it is a good idea to keep the coverage if you cannot afford to replace the vehicle in the event of an accident.
The main point is that if you own the car, it is easier to sell it and you can reduce your insurance costs.
Lower chances of being returned
Sometimes cars depreciate faster than the amortization schedule of an auto loan. This is especially true if the repayment period is long or the interest rate is high.
It is not easy to end up with a reverse loan, that is, a debt that exceeds the value of the car. You may run into problems if you try to sell or trade the vehicle or if it is scrapped. In any case, you may have to pay the difference to your lender in a lump sum, although most lenders will allow you to carry the amount over to the new loan if you trade in the vehicle.
Key point: understand how the vehicle will depreciate and avoid having to pay more money on the loan than the car is worth.
Improve the debt-to-income ratio
The debt-to-income ratio is the percentage of your gross monthly income allocated to debt payments. It helps lenders determine how much you can afford to borrow. The higher the debt-to-income ratio, the more likely you are to be a risky borrower.
Early car repayment removes the car loan from the equation. Your DTI will naturally be lower, which opens the door to other forms of credit. It also helps improve your chances of refinancing other loans or consolidating credit card debt at a lower rate.
Things to remember: A lower DTI ratio can help you get better credit in the future.
Freeing up money for other expenses
According to an Experian report, the average monthly payment for a new car was $667 in the second quarter of 2022.
Paying off your car loan is a great opportunity to achieve other financial goals. If you keep the car you have and do not take out another loan, you can put the money toward vacation savings, retirement funds or other debt.
And even if you purchased a used car, the average lower payment of $515 can make a significant difference to your budget.
Inconclusion, leave a few hundred dollars a month in your budget.
Disadvantages of paying off your car loan early
Closing and prepayment penalties can have an impact on your finances. While there are advantages to paying off your car loan early, there are also potential disadvantages to consider.
Early repayment penalties
Some lenders charge a penalty if you pay off your car loan early or make extra payments. Check your loan agreement to see if your lender charges one.
If your lender charges an early repayment penalty, compare the cost with the savings you could make by accelerating your repayment plan. If it is too expensive, keep paying the loan on time and use the extra money for other things.
Reduce your credit rating.
If you stop paying a loan because you have paid it off, your positive payment streak will end. In addition, your credit rating may be affected by the fact that the credit bureaus examine both installment loans, such as auto loans, and lines of credit, such as credit cards.
Don't let the fear of a credit downgrade keep you from paying off your auto loan earlier than expected. This potential downgrade is usually small and temporary, and if you continue to manage your credit accounts responsibly, it should not be a problem.
Money better spent elsewhere
If you have debt with a higher interest rate, it may be best to focus your efforts first on those loans or credit cards. This includes credit cards, some personal loans, and short-term debt.
Even if you do not have high-interest debt, your money may be more effective if it is in a retirement account, health savings account, or other tax-advantaged financial account. The same is true for general investments if the interest rate on your auto loan is low.
This may not be compatible with your overall budget
If your budget is tight, it may be impossible to find extra money to put toward your car loan payment each month. Even if you manage to save in other areas, other aspects of your financial life (such as high-interest debt, retirement, and emergency funds) may be more important.
Before you decide to pay off your loan early, take the time to examine your budget and make sure it does not put you in an even more precarious position.
How to pay off an auto loan early
Depending on the availability of money, there are three ways to pay off your car loan early.
Pay it off in full
If you have received a substantial bonus at work or a tax refund, or if you have saved some money, you can make a lump sum payment to pay off your car loan in full.
To do this, find out how much you can repay in 10 days, including interest accrued since the last payment. Then send a check to the lender or make the payment online to bring the balance to zero.
Partial lump-sum repayment
If you do not have enough money to pay off the entire balance, you can make a large payment to pay off a large part of the balance. This will not reduce the monthly payment, but it can significantly reduce the duration of the debt. Also, since this payment will be applied to the principal, you will pay less interest in total.
Increasing the monthly payment
If you do not have a large amount of money to spend on your car loan, consider increasing your monthly payments. You can decide how much more you want to pay. Even a small amount can save you money and time.
At a glance.
Paying off an auto loan early can save you money, as long as the lender does not charge an excessive penalty and you do not have other high-interest debts. Even a few extra payments can help reduce costs.
Before rushing to pay off your car loan, do the math to determine if it makes financial sense or if the extra funds are better used elsewhere. Also consider your financial situation and goals to weigh the pros and cons and determine the best strategy for you.
