The short answer to this pressing question is yes. 

When you pay off your car loan early, you save money in interest compared to if you had continued paying for the full loan term. The amount you save will depend on a few different factors, such as your loan type and what your auto financing contract includes. 

There might also be some lesser-known disadvantages to paying off your loan early. 

Advantages of Paying Off Your Loan Early

Paying off your car loan early has tons of advantages. It puts you one step closer to financial freedom by lowering the total amount of debt you owe, lowering your debt to income ratio, and increasing your disposable income. 

Instead of paying months or years’ worth of extra interest to a lender, use that money to help you achieve other financial goals. 

Save Money on Interest

The most obvious advantage in paying off your auto loan early is that you’ll pay much less in interest. Sometimes this can save thousands of dollars depending on the time you have until the end of the loan term. Not all car loans are created equal though.

The type of loan you have plays a large part in how much you could save. If you got your car loan through a bank or credit union, you might have a loan with precomputed interest. 

This means the interest charges on your loan are fixed. So even if you pay the loan off early, you’re still paying the total interest that was calculated at the start of your loan. To find out if you have precomputed interest, you’ll have to take a look at your loan contract. 

The other type of loan you might have is a simple interest loan. These vehicle loans calculate your interest charges based on what you currently owe. 

Simple interest works to your benefit if you’re looking to make a lump sum or extra principal payment on your car loan. So the sooner it’s paid off, the less interest you pay. 

As long as there’s no prepayment penalty on your simple interest loan, you’re in the clear to save money. Even if your auto loan paperwork states that there’s a prepayment penalty, it might still be worth it to pay it off. We’ll get more into that later.

Save on Insurance Cost

Even though you have the car title, your auto lender technically owns the car until you pay it off. Sometimes they’ll require higher car insurance premiums to protect their asset (your car) in the event of an accident. 

Once you make your final car loan payment, you’ll own your vehicle. Then you get to decide what level of insurance coverage you’d like to keep.

Calling your insurance agency for a readjustment can be an easy process. Oftentimes this can save you some extra money in addition to not having a monthly car payment.

Helps in Lowering Debt to Income Ratio

Lenders love to see a low debt to income (DTI) ratio when you apply for a mortgage, personal loan, credit card, or other credit lines. Underwriters look for healthy DTI ratios to determine how much of a loan or line of credit you can be approved for. 

If your goal in paying off your auto loan is to afford a home purchase, you’re taking the right steps. Paired with a good credit score, a lower DTI can be a deciding factor in financing a new home or getting a new car. 

The money you save each month can also contribute to your down payment, effectively earning you a lower interest rate on the borrowed funds. 

If you’re looking to trade in your old car for a new one after paying it off, make sure your credit score is up to par by reading What is A Good Credit Score to Buy a Car. 

Frees up Your Funds

According to Experian, the average monthly payment on a used car in 2021 is $430. The average payment for a new car is a bit higher at $575 a month. 

By paying off your car note early, there’s no doubt you put extra money back in your pocket. You’d be surprised what you can do with an extra $400 to $500 each month. 

There are plenty of responsible things you can spend the added cash flow on… and probably some irresponsible things too. Let’s use the money to take care of the essentials first:

• Paying off high-interest debt
• Building an emergency fund
• Saving for the future
• Catching up on other bills
• Making quality of life improvements

Using the funds to pay off other high-interest debts is smart. Keep the debt payoff train going and save even more money in interest. 

If you depleted your savings to decrease your debt, now is a good time to start refilling your account. It wouldn’t make much sense to pay off your car and still not be able to cover an emergency now, would it? 

Save for a down payment on a house or use the money to save up for expensive home improvements. Look for investments that return more in interest than you were paying on your car loan.

You can even improve your quality of life by making a purchase you’ve been putting off for a while. Get a quality mattress, a better gym membership, or even a TSA precheck if you’re a frequent flyer. The possibilities are endless!

Avoid Owing More Than Your Car Is Worth

In recent years, auto lenders have gotten in the habit of extending loan terms beyond the typical five-year or 60 month repayment period. 

Yes, it enables people to afford monthly payments on cars that otherwise are out of their price range. It also has the adverse effect of putting you underwater on your car loan. 

When lenders extend the loan term up to 84 months, it doesn’t allow you to outpace the rate of depreciation before the end of the car loan. That leaves you with negative equity on your car. Making it more difficult to trade in your vehicle or sell it since you owe more than it’s worth. 

If you unknowingly got into a long loan and are looking to get out of it, you have some options. 

You can choose to refinance your car with a shorter loan term than your original auto loan.  Another option is to make extra payments toward the principal balance to pay it off faster. 

Disadvantages of Paying Off Your Loan Early

While paying off your loan early can come with some significant advantages, you have to be aware of the downsides too.

Prepayment Penalties

Prepayment penalties are in your loan paperwork. It consists of a fee if you pay off your car loan early. This benefits the lender by helping them recoup the lost interest payments they were banking on. 

In some cases, the penalty could be the entire remaining interest expense. Make sure to read the terms in your loan contract for specific details on the penalty amount. 

That’s why many people prefer to lease a car instead. Even if your credit isn’t the best, you can learn how to lease a car with bad credit. Get the latest car models without the long-term commitment. 

If there is a penalty involved, you might still save some money by paying off the loan early. Use a financial calculator to compare the penalty fee with the total interest you would save by making additional monthly payments. 

You might also be able to avoid this by refinancing your vehicle loan to one with better terms. 

Your Credit Score Takes a Hit

When you pay off a loan, car loan, student loan, or personal loan,  it doesn’t stay open for use like a credit card would. It closes out and is no longer contributing to your credit mix. To combat that, look into getting a credit builder loan after your big payoff.

Unless you have other installment loans in your credit history, paying off your car loan can cause your credit to dip. This is only temporary, but it can be confusing since you’re making the responsible choice by paying off debt. Don’t worry, your credit score will bounce back.

Many times, when you get a car loan, it helps you raise your credit score significantly within a few short months of on-time payments. If you were using the car loan to build your credit and are thinking of paying it off much sooner than scheduled, learn more about how fast a car loan can raise your credit. 

Could Use Funds for High-Interest Debt

Paying off your car note is an admirable achievement, but is it the most effective way to eliminate your debt? If you have other debts with a higher interest rate, it might be better to pay those off first instead of knocking out your car payment. 

Your goal is to pay less in interest, right? Tackle the credit card at 23.99% or the student loan at 9.5% first so they don’t continue accruing interest. Unless your auto loan’s interest rate is in the double digits, you might be able to wait before paying it off. 

How to Pay Off Your Car Loan Early

Lump-Sum

This usually happens when you’ve come into a large chunk of money at once. Whether it’s a work bonus, tax refund, inheritance, or disciplined savings, it can help you reach your payoff goals. 

Even if you don’t have the full amount on hand, you can still make a partial lump-sum payment which will decrease the amount of interest and may affect your monthly payments afterward.

Increased Monthly Payments

This strategy takes a little more planning but is still effective. There are a few different ways you can do this depending on the income at your disposal. If you can afford to, the fastest way to tackle your car loan debt is to make biweekly payments each time you get paid. 

Just be careful to make sure that your secondary payment is counted towards the principal balance. You could also make your regular payments with a rounded-up amount. 

So if your normal payment was $320, you could round it up to $400. This leaves an extra $80 towards the principal each month. It might not seem like much, but it adds up quickly. Making larger payments can lower the amount of principal that you’re making interest payments on. 

Even making one additional monthly payment can save you money on interest. If you find yourself with some extra funds from time to time, you can make an additional payment to reach your payoff that much faster.

Pay It Off in Full

Making a full payoff is difficult for most people to do. It can be done if you come into a large amount of money or manage to save up for it. 

To knock out your car loan in full, you’ll have to get the 10-day payoff balance from your lender. This can be done by calling in or going online. From there you can send in the final payment to close out the loan. 

So when does it make sense to pay it off? 

You should make the effort to pay off your loan when it’s not sacrificing your other financial goals, like saving for a home or paying off high-interest debt.

It can also make sense when you have a significant amount in savings already, but it’s not earning nearly as much as you’re paying in interest. 

If you have a simple interest loan with no prepayment penalties, then the payoff is a no-brainer. Just make sure to keep an ample emergency fund, just in case. 

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