Should I Pay Off My Car? Make the Wise Financial Move
Paying off debt as quickly as possible is ideal, but your car loan may be an exception.
Contributing Writer at Tally
September 20, 2021
A car payment is often one of the highest monthly expenses for many consumers. According to Experian, the average monthly payment for a new car is $554 and $391 for a used car. With such a high monthly payment, it may seem to make sense to pay off your car loan early and free up some extra cash for other uses.
While this is true, there are some considerations when deciding if paying off your car loan is a wise financial move.
If you find yourself wondering, "Should I pay off my car?" we’ve got you covered with all the benefits and drawbacks to doing so.
What are the benefits of paying off a car loan early?
When paying off a debt early, there's usually a slew of benefits that go along with it. Paying a car loan off early is no exception.
Saving on interest
Most debts, car loans included, charge interest. The amount of interest you pay is based on the interest rate and loan amount. So, as you pay down the loan balance monthly, the amount of interest you pay also decreases.
When you pay off your car loan, you bring the principal balance to $0, meaning you pay no more interest moving forward. This could save you thousands of dollars in interest payments over the life of the loan.
Increasing cash flow
Since your car payment is generally one of the highest monthly payments you have after your mortgage or rent, paying this off frees up that monthly cash. You can apply this extra cash to other things, like building an emergency fund, paying off your mortgage or saving for retirement.
Turning a liability into an asset
When you owe money on a car loan, your car is more of a liability than anything. However, once you pay off the vehicle and the lender releases the title to you, the vehicle is now an asset.
You can sell the vehicle and keep 100% of the proceeds or use it as a trade-in on a new car if needed. You can even borrow against its value if you ever hit a tough spot financially.
Improving debt-to-income (DTI) ratio
When you have a car payment, it counts toward your debt-to-income (DTI) ratio. Many banks look at your DTI ratio when considering you for a loan. If your DTI ratio is too high, they may reject your application, even if you have a good credit score.
By paying off your auto loan, that loan payment no longer impacts your DTI ratio.
Cutting insurance costs
When you're financing a vehicle, the lender generally requires pricey full-coverage insurance. However, many states only require liability coverage, which pays for the damages you cause in an accident but doesn't cover the damages to your vehicle.
Once you pay off your auto loan, you could downgrade to less expensive liability insurance and save money. Keep in mind, if you total your vehicle on liability insurance, your insurance provider won’t pay to fix it.
What are the downsides of paying off a car loan early?
There are plenty of benefits to paying off your auto loan early, but there are few downsides to it, too.
Potential credit score reduction
Credit mix — the mixture of different kinds of credit accounts, such as revolving debt and installment loans, on your credit report — makes up 10% of your FICO credit score. Paying off your car loan closes an installment loan, which could throw off the mixture if you have credit card debt on your credit report.
Throwing off this balance could result in a slight credit score reduction.
Though they're not overly common these days, prepayment penalties still exist in some auto loans and can negate the benefits of paying them off early.
Lenders grant loans with the expectation of profiting off the interest they charge. If you pay off the loan too early, the lender loses some profit. The lender can capture some of this lost interest by tacking a prepayment penalty onto your payoff amount if you pay it off too early.
Before paying off your car loan, verify your loan doesn't have a prepayment penalty or that you're past the timeframe where the lender charges this fee.
If a lender does charge this fee, verify that your interest savings from paying it off early are greater than the prepayment penalty before proceeding.
Missed investment opportunities
When you make a lump-sum payment or even additional monthly payments with the goal being to pay off your car loan, you're bypassing other money-making opportunities, like investing.
On average, investing in the stock market nets a 10% return annually, but many experts recommend expecting a 6% return due to market volatility and inflation.
The average interest rate on a car loan is 2.34% for super-prime borrowers and 3.48% for prime borrowers, according to the "State of the Automotive Finance Market Q2 2021" report. On used cars, these rates increase to 3.66% and 5.49%, respectively.
In any of those cases, you're better off investing the extra cash or placing it in a retirement savings account and allowing the interest to collect than paying off a low-interest car loan.
So, before paying off your car loan early, check your interest rate and compare it to the average return in the stock market.
As with all investing, meet with a financial advisor or investment professional before investing to ensure it's right for you.
Other uses for the cash
Sometimes, the excitement of paying off your car overshadows other places that money could help. For example, if you have high-interest debts, like credit cards or personal loans, it's likely better to pay off those debts first.
If you have no other debt, maybe this cash could go toward building your emergency fund or reaching other personal finance goals.
Should I pay off my car early?
Status of financial goals
Car loan interest rate
Other outstanding debts
In many cases, though, it’s not financially wise to pay off an auto loan early because car loan interest rates are often significantly lower than the return on investments. The one consistent exception is if your goal is to simply free up some monthly cash flow to meet other financial goals.
If high-interest credit cards are delaying your car loan payoff or are just becoming troublesome in general, the Tally† credit card debt repayment app can help. This app rolls all your credit cards into one monthly payment and includes a lower-interest line of credit. With its line of credit, you can pay off higher-interest rate credit card debt quickly and save money on your total interest charges. Plus, you can use this line of credit multiple times to pay off multiple credit cards.
†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.