December 22, 2023

Driving Away From Debt: Paying Off a Car Loan Early

Paying off a car loan early can shift your personal finances into high gear. By steering clear of this debt ahead of schedule, you free yourself from monthly obligations and start a journey toward a healthier financial future.

This choice can pave the way for reduced interest expenses and offer a big sense of accomplishment. Early repayment is also a good idea if you plan to apply for a mortgage or other significant loan because it can improve your debt-to-income (DTI) ratio.

Let's dive into the essential factors for any borrowers considering paying off a car loan early.

When is paying off a car loan a good idea?

Should you pay off your loan early? It could be very beneficial but ultimately may depend on your financial situation.

Evaluate your current finances before you rush to zero out that outstanding principal. Do you have an emergency fund in place? If not, that may be a higher priority to insulate you from emergencies.

Next, assess the interest rate on your best auto loan. If it's higher than what you could earn from investments or savings, paying off the debt is a smart option. If not, you may be better off using that money to make even more. You might also consider refinancing the loan.

Then weigh your car loan against other outstanding debts. If you have high-interest debts, like credit card balances or cash advances, it’s likely smarter to tackle those first.

Finally, think about your financial goals. Liquidity could be important to you if you have a significant investment or purchase on the horizon, which could mean holding off on paying off that loan. But paying off that debt could also put you in a position to open a new loan for what you’re eyeing next, possibly at a better rate.

Advantages of paying off a car loan early

There are many pros and cons to paying off a car loan early. Here’s what you can expect to gain:

1. Financial flexibility

Clearing your car loan early means you can reallocate that chunk of your monthly budget to other priorities. Whether saving for a vacation, investing in a new venture, or simply boosting your savings, you'll have more financial flexibility.

2. Save on interest

Your debt accumulates interest each month. Settling your car loan ahead of its tenure will significantly reduce the interest you ultimately pay the lender, saving you money in the long run. This is particularly beneficial if you took out the loan at a time when interest rates were high.

An auto loan calculator or payoff calculator can help you visualize these savings. A payment calculator can also tell you whether or not it is worth refinancing your auto loan.

3. Boosted credit score

Consistent, timely payments and reduced overall debt can positively impact your credit score. The impact depends on your credit history and total credit portfolio.

A healthy credit score benefits future financial endeavors, opening doors to better loan terms, credit card offers, and even favorable insurance premiums. That’s why monitoring your credit is so important.

4. Peace of mind

There's an undeniable sense of relief that comes with being debt-free. By settling your loan early, you no longer have to think about your monthly car payment and the stress and limitations that come with it.

Disadvantages of paying off a car loan early

Although it can save you money and stress, paying off your car loan ahead of schedule isn’t a guaranteed win. These are some potential downsides:

1. Potential prepayment penalties

It's important to read the fine print. Some lenders charge you a fee for the privilege of clearing your debt before it’s due. The penalties of paying off a car loan early could add unexpected financial strain and offset savings from avoiding interest.

2. Opportunity cost

The funds you use to clear your car loan could be invested elsewhere. If those investments offer a higher return than the interest on your car loan, you’re missing out on potential gains.

3. Temporary dip in credit score

Does paying off a car loan early hurt credit? It’s complicated.

Reducing debt is generally good for your credit score, but closing an account can cause a short-term dip in your credit score. Be aware of this possibility if you plan to apply for a loan or undergo a credit check in the near future. Diversifying your credit through credit cards and personal loans can mitigate this effect.

4. Loss of tax deductions

The interest on loans might be tax-deductible. If you qualify for a deduction, you’ll miss out by paying off your car loan early.

How to pay off a car loan early

A few proactive steps can help you clear your car loan faster than you think. Consider these strategies:

- Make biweekly payments. Instead of sticking to the traditional monthly car payment schedule, consider splitting your monthly payment in half and paying every two weeks. These 26 half-payments add up to 13 whole payments a year instead of the usual 12. That extra payment adds up over time.

- Rounding up payments. If your monthly installment is $285, why not round it up to $300? These small additions will help you pay off your auto loan faster without feeling a major pinch in your budget.

- Refinance the loan. If interest rates have dropped or your credit score has improved since you took out your auto loan, you might qualify for a lower rate. Auto refinancing reduces your monthly car payment or shortens your loan term if you maintain the same payment. Platforms like MyAutoLoan or Bankrate compare auto refinance options from various lenders.

- Use bonuses or tax refunds. Instead of splurging with unexpected income, consider using a portion to pay a lump sum to your lender.

EarnIn helps drive you toward a debt-free future

Paying off a car loan early is a commendable goal, just be sure it aligns with your broader financial strategy. You can drive toward a future free from car debt by taking informed steps, like refinancing, and using tools like Earnin.

The EarnIn app offers powerful tools to give you a new set of options with your money. Our Cash Out tool lets you access your pay as you work — up to $100 a day and up to $750 every pay period — so you have what you need to keep moving forward.

Download the EarnIn app today and discover money at the speed of you.

Please note, the material collected in this post is for informational purposes only and is not intended to be relied upon as or construed as advice regarding any specific circumstances. Nor is it an endorsement of any organization or services.

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