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Does it allow early repayment of the car loan?
by
Irene Scott
October 3, 2023
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Whether you choose to pay off your car 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 debts or urgent high-interest expenses. On the other hand, if the money could be better spent elsewhere, paying off the car loan early may not be the best choice.
When is it a good idea to pay off an auto loan early?
In some cases, it may be appropriate to focus your efforts on eliminating car loan debt. Check to see if this is the case for you:
- You do not have high interest rate debt and want to free up money for other financial goals.
- The car loan interest rate is higher than you could get by investing.
- You hope to buy a house soon and want to reduce your debt ratio.
- You have recently come into a sufficient amount of money to cover emergencies.
- You want to grow your savings account faster so that you have funds available 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.
Benefits of early car loan repayment
If you can, early car loan payoff can have significant benefits.
Interest saved
Interest is generally 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 one 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 by paying a single amount on your loan.
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 have the title in your own name. It also means that you will have more options if you intend to sell or trade-in the vehicle.
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 better to keep the coverage if you cannot afford to replace the vehicle in case 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 if the interest rate is high.
It is not easy to end up with an inverted loan, i.e., 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 all cases, 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 repayment. It helps lenders determine your loan amount. The higher the debt-to-income ratio, the more likely you are to be a risky borrower.
If you pay off your car early, your car loan is removed from the equation. Your DTI will naturally be lower, which will open the door to other forms of credit. It also increases the chances of refinancing other loans or consolidating credit card debt at a lower rate.
Things to remember: A lower DTI ratio can help you obtain 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 an excellent opportunity to achieve other financial goals. If you keep the car and do not take out another loan, you can use the money to save for vacations, retirement, or to pay off other debts.
And even if you bought a used car, the average payment reduction of $515 can make a significant difference in your budget.
In conclusion, 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 repay your car loan early or make extra payments. Check your loan agreement to see if your lending institution imposes such a penalty.
If your lending institution imposes an early repayment penalty, weigh the cost against the savings you could achieve by accelerating your repayment plan. If it is too expensive, continue to pay the loan on time and use the extra money for other purposes.
Reduced credit rating.
If you stop paying a loan because you have repaid it, your string of positive payments will stop. 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 rating downgrade keep you from paying off your auto loan as soon as possible. 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 high interest rate, you may be better off focusing your efforts on those loans or credit cards. These include credit cards, some personal loans, and short-term debt.
Even if you do not have high-interest debt, your money might be more effective if placed 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.
It may not be compatible with your overall budget
If your budget is tight, it may be impossible to find extra money to pay off your car loan 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 do you pay off an auto loan early?
Depending on the availability of money, there are three ways to pay off an auto loan early.
Full repayment
If you have received a substantial bonus at work or a tax refund, or if you have saved some money, you can pay a lump sum to repay your car loan in full.
To do this, calculate 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 repayment in a lump sum
If you do not have enough money to pay the entire balance, you can make one 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.
Increase the monthly payment
If you do not have much money to spend on your car loan, consider increasing your monthly payments. You can decide how much more to pay. Even a small amount can save you money and time.
In summary
Paying off an auto loan early can save you money, as long as the lender does not impose an excessive penalty and you do not have other high-interest debts. Even a few extra installments 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.
