Auto debt is at record levels in the United States with Americans owing more than $1.5 trillion on their car loans. A car is a necessity for most people and few people can afford to make a lump sum payment to buy one, so it makes sense that most people turn to auto loans.

If you have an auto loan and you’re thinking about paying it off early, it’s important to know both the benefits and disadvantages of paying off a car loan early.

The 3 Main Disadvantages of Paying Off Your Car Loan Early

It Could Hurt Your Credit Score

One counterintuitive result of paying off your car loan is that it could hurt your credit score.

There are many factors that influence your credit score, including your length of credit history, credit utilization, different types of debt you may have, and payment history. 

For example, having a credit card, student loan, and auto loan will show that you can handle a mix of different types of debt.

Paying off a car loan will change that account from “active” to “closed” on your credit report. If you have a thin credit profile, that can cause your score to drop. This is because closed accounts have less of an effect on your credit scores than open accounts.

Your active auto loan account positively affects your credit mix, payment history, and credit utilization. When it closes, it has less of a positive impact on those credit scoring factors. 

Diminished Cash Reserves

If you pay off your car loan by making a single lump sum payment, you’ll decrease whatever savings that you have. 

If you deplete your emergency fund and wind up facing an unexpected expense or financial emergency, it can be a big problem. Your cash will be tied up in your car instead of available for you to use.

If you’re applying for a mortgage or other home loan, such as a home equity loan, lenders might also want to see that you have cash on hand. If you spend it to pay off a car loan, you might have trouble getting a mortgage.

Prepayment Penalties

One of the ways that lenders make money is by charging interest on the money that you borrow. If you pay your car loan off early, your lender will collect less interest in the long run, which means it is losing out on money.

To combat this, some lenders will charge a prepayment penalty to discourage people from making biweekly payments instead of monthly ones or paying off an entire loan in one lump sum. 

This can also make it harder to refinance your car loan. When you refinance, you get a new loan and use that money to pay the old one off. That means refinancing may also incur the prepayment penalty.

This is less common with more community-focused institutions, such as a credit union. If you want to pay your loan off before the loan term ends, keep that in mind when applying for a car loan.

Depending on the interest rate of your loan, you might still save money by paying the loan off early and paying the penalty, but the penalty will reduce your savings.

The 3 Main Advantages of Paying Off Your Car Loan Early

Save on Interest

One of the top reasons to pay a car loan off before its full repayment term is that you can save money on interest.

Your lender will charge interest on the money you borrow. The higher the interest rate, the more you’ll pay over the life of the loan. Every extra payment you make toward the loan will reduce the loan’s principal, thus reducing the interest payments you have to make in the future.

The savings will be bigger if you have a higher interest rate rather than a lower interest rate. That means it’s typically more advantageous for people with bad credit, and therefore higher interest rates, to pay off their loans early.

Take Full Ownership Sooner

As long as you still have a loan balance, your lender has a lien on your car. That means that if you stop making payments toward your car loan, the lender can repossess your car and sell it to recover some of the money it lost by financing the purchase.

That lien can also complicate things like selling your car to someone else or trading it in if you want to purchase a new vehicle. You may also have to deal with more stringent insurance requirements imposed by your lender.

Paying off your loan means having more freedom to do what you want to do with your vehicle.

Free Up Funds for Other Expenses

If you pay off your car loan early, it means you no longer have to worry about paying that bill every month. You’ll have more cash in your budget to handle other expenses.

For example, you can take the money you’re no longer using for car loan payments and put it toward paying down high interest debt, such as your credit card balance or student loan debt. You could also add it to your monthly mortgage payment to help you build equity faster.

If you use your extra money each month to build home equity, you can later use that equity to get a low interest loan that you can use for debt consolidation. That can help you turn expensive, unsecured debt (like credit card debt) into debt with a lower monthly payment.

Using the money you saved from getting out of your monthly car payment to pay down other debts is one of the best things you can do to save money in the long run.

Avoid Owing More Than Your Car Is Worth

One aspect of car finance that you don’t see with other expensive assets is that cars tend to lose value very quickly when you drive them off the dealer’s lost. You can easily find yourself owing more than your car is worth.

Having negative equity can be very bad if you ever need to sell your car or try to refinance your loan. If you owe $15,000 on a car worth $12,000, you’ll need to come up with the extra $3,000 to repay your debts if you want to sell the vehicle.

Similarly, refinancing your car loan will be difficult because lenders won’t want to lend you more than the car is worth. You might have to make an additional payment to bring the loan balance down below the car’s value as part of the refinancing process.

When is it Okay to Pay Off a Car Loan Early?

There are a few scenarios when paying off a car loan early can make sense.

One is when your car loan has a high interest rate. Paying off a loan is like earning a return on investment equivalent to the loan’s interest rate. 

Paying off a loan charging no interest won’t save you money and will actually incur an opportunity cost. On the other hand, paying off a car loan charging 10% can save you a huge amount.

It’s also important to consider your overall financial situation. If you have a huge emergency fund that you won’t deplete by paying off your car loan, then putting that extra cash toward your debt won’t leave you in a bad situation.

Similarly, if you have money on hand, but have cash flow problems, paying off your car loan can free up some space in your monthly budget. 

Having that extra flexibility can make it much easier to handle all of the expenses that come up each month and stop you from feeling like you’re living paycheck to paycheck.

When is it Not Okay to Pay Off a Car Loan Early?

There are a few situations where paying off your car loan is a bad idea.

One is if the loan has a very low interest rate or even charges no interest. If you can earn more interest from an investment account than your loan charges, you’ll be better off keeping the loan as long as possible because you’ll earn more than you’d save by paying off the loan.

Paying your car loan off early is also not a good thing to do if money is tight. If you’ll have no savings left after paying off the loan, it’s better to keep a cash cushion that you can use if something unexpected pops up.

Without that cushion, you might have to turn to expensive credit card debt to handle a financial emergency.

Another bad time to pay off a car loan is when you are relying on that monthly payment to build your credit. 

If you have a car loan, each monthly payment you make helps you build your payment history. If you want to know how to get an 800 credit score, a perfect payment history is the first step.

As long as the interest rate of the loan is reasonable, keeping the loan to build your payment history is reasonable. This is especially true if you’re rebuilding damaged credit or building your credit for the first time.

FAQ’s

If you pay off a car loan early, do you save interest?

Yes, when you pay your car loan off early, you will save money on interest.

Consider this simplified example: You owe $10,000 on a loan that charges $500 in interest every year. If you pay the loan off over five years, you’ll be charged $2,500 in interest. If you pay the loan off after the second year, the lender will only charge $1,000 in interest.

Once you pay off your car loan, the lender will stop charging interest, so you’ll pay less interest overall.

Is it bad to pay off a car loan early?

Paying off your car loan early usually isn’t a bad thing to do, but there are some situations where it can be bad. For example, if you use all of your savings and have no cash cushion, that’s a bad thing.

It’s also a bad thing if you’re relying on your car loan payments to build your credit score. 

How long does it take to build credit? The answer depends on your starting point. It’s easier if you have no credit than if you have damaged credit but either way, you should have solid credit after a year or two of timely payments. 

It can be worth keeping the loan for at least that long so you can improve your credit score.

Conclusion

Paying off your car loan early can help you reduce your monthly budget and save money on interest, but there are important drawbacks that you need to be aware of. Think about both sides of the equation before you pay off your car loan early.

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