What Are the Disadvantages of Paying Off a Car Loan Early?
Paying off a car loan early has its perks, but there are some disadvantages that are also worth considering.
Contributing Writer at Tally
May 5, 2022
As you get into the later months of your car loan, you may find yourself wondering whether it makes sense to pay the loan off early in its entirety. There are both advantages and disadvantages to paying off a car loan early. Whether it’s the right decision for you depends on your personal finances.
Learn more about the advantages and disadvantages of paying off a car loan early, so you can decide whether it’s the right financial move for you.
The disadvantages of paying off a car loan early
There are more than 100 million outstanding car loans in the United States. If you have one (or more) of them, you may be wondering whether it’s a smart move to make extra payments to get out from underneath your auto loan debt sooner.
Let’s take a look at some of the disadvantages of paying off a car loan early.
You may face prepayment penalties
Many lenders put prepayment stipulations into their loan terms. This essentially means that if you pay off your car loan early, you owe either a fixed fee or a percentage of your outstanding balance. For instance, your lender may have a fixed penalty of $500 or charge you 2% of the outstanding balance. If your outstanding balance was $2,500, your prepayment penalty would be $50.
One thing worth considering is whether the prepayment penalty is less than what you’re paying in interest. For example, if you’ll owe 2% of your outstanding balance as a prepayment penalty, but you have a 4% interest rate, it may be worth paying off your loan early if you have the extra cash available to do so.
Your credit score may decrease
When considering paying off your loan, you may ask yourself, “How much will my credit score increase after paying off my car loan?” Unfortunately, the opposite scenario may occur — your credit score will likely decrease when you pay off your loan.
Your credit report — which is used to determineyour credit score — factors in your oldest/longest-held credit accounts and your credit mix (whether you have multiple types of credit, such as auto loans, student loans, personal loans and credit cards).
When you pay off your auto loan, you could possibly be closing one of your older accounts and also potentially closing one of your only sources of credit mix.
That said, these things will inevitably happen whenever you pay your loan off, so a possible drop in your credit score is only a disadvantage if you are planning to borrow money soon.
Let’s say you’re preparing to borrow a significant sum of money, such as a mortgage. It could be wise to keep your credit score as high as possible. In these cases, you might not want to put extra money toward the remaining balance on your auto loan until after you’ve secured a mortgage.
The money could be better used elsewhere
Making your final car payment is a rewarding experience. But one of the cons of paying down the debt early is that it could be costing you money. If you have debt with higher interest rates, you may be better served making payments toward that debt.
Your car loan may have the lowest loan balance. If so, paying it off first is considered the debt snowball method
If you pay your high-interest debt first, such as credit card debt, you’ll be implementing the debt avalanche method
There are benefits to both methods. But if you’re being charged more on high-interest debt than you’d save by paying off your car loan early, you may want to take a closer look at your repayment strategy.
The advantages of paying off a car loan early
There may be some downsides to paying off your car loan early, but there are several upsides as well. Let’s take a closer look at the benefits of paying off a car loan early.
You free up cash
Perhaps one of the biggest benefits of paying off a car loan early is that you free up cash to use elsewhere. For instance, let’s say you have a car payment of $200 per month. You put a little extra toward your loan amount each month and end up paying off your loan two months early.
However, you’ve already budgeted for those $200 car payments for the next two months. You can now redirect this $200 each month elsewhere. Maybe you put your money toward an emergency fund or savings account, start saving for a down payment on a home, or perhaps you put it toward a student loan payment.
You save on interest
By putting more money toward your principal, you will ultimately end up paying less interest, assuming you have a simple interest rate. A simple interest rate means your lender determines the amount of interest you owe each month based on your outstanding balance. By making extra payments, you’ll lower your balance and, therefore, lower how much you owe in interest.
Let’s say you come into some money via a tax refund. Instead of putting this money toward a vacation or new clothes, you could consider making a lump-sum payment toward your car loan. This will lower your balance and save you money on interest. Then, you can put the money you saved toward other financial goals.
This strategy is not possible if you have a precomputed interest rate. With a precomputed interest rate, your interest payments are determined at the beginning of the loan. Your lender will determine the total interest owed and divide that by the number of months in the loan term. This means the amount you owe is fixed. Paying it off early may help you free up cash, but it won’t save you money on interest. You can read your loan terms to figure out which type of interest you have.
Your car insurance rates may decrease
When you take out a loan to purchase a new car, the lender technically owns the vehicle until you pay off the balance in full. This means you’re required to pay for comprehensive and collision coverage. Now, you can still keep these on your policy when you pay off the loan and own the vehicle outright, but you are not required to.
Cutting these from your policy could, therefore, cause your car insurance rates to decrease. However, it’s wise to work with your insurance agent to ensure you’re still receiving the level of coverage you need to feel safe on the road.
Paying off your car loan early could help you manage your debt
When it comes to managing debt, paying off a car loan early could be a strategy worth considering. However, there are a few disadvantages of paying off a car loan early, like prepayment penalties or a temporary drop in your credit score. Taking time to look into your loan terms, interest rates and the other types of debt can help you make an informed decision.
Having said that, though it depends on your personal financial situation, the advantages of paying off a car loan early typically outweigh the disadvantages. If you make the financial decision to pay off your auto loan early, not only will you save on interest, but you’ll also free up money by not having to make monthly payments. You can redirect these payments to other sources of debt, such as your mortgage or credit cards.
If you’re looking for ways to help manage your debt, you can consider Tally†. Tally helps qualifying users pay down credit card debt quickly and efficiently with a lower-interest line of credit, so they can reach their financial goals faster.
†To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. The APR (which is the same as your interest rate) will be between 7.90% and 29.99% per year and will be based on your credit history. The APR will vary with the market based on the Prime Rate. Annual fees range from $0 - $300.