Debt is oftentimes one of those necessary evils in life. Without it, most of us would be unable to buy cars, homes, or a whole host of other expensive purchases. After we take financing, though, common financial guidance suggests that you should pay off all of your debt as quickly as possible.
Doing so may save you money in costly interest.
But is paying off a loan early always worth it?
The answer may surprise you. Here are three times when paying off a car loan early actually isn't worth it.
Can you pay off a car loan early without penalty?
This will largely vary by lender or financing company, but in many cases, you can pay off your loan at any point. You'll want to look out for any sort of prepayment penalty or early termination fees, as these can make your ultimate repayment more costly than it needs to be.
I bought a Honda Accord LX in July 2019 and financed my purchase via a sixty-month loan at 2.9%. At the time, I was bummed, since the Federal Reserve had recently raised rates a couple of times before I made my purchase.
Of course, at the time, I couldn't foresee the future of interest rates and that they would soon be much higher.
Anyway, over the last couple of years, I've nearly paid off my vehicle a number of times, only to decide against it, for reasons I'll get into. But had I decided to, my Honda Financial account actually gives me a payoff price that varies by day.
It takes into account the number of payments left in my loan's term, as well as the interest that accrues on a daily basis. This means that over a course of a month, before I make my monthly payment, the estimated payoff amount actually increases as the interest for that month accrues.
Again, whether or not you are allowed to is lender dependent, but more lenders than not will allow it, from my experience.
How to pay off a car loan early
If you're looking to pay off your car loan early, you have four main options to do so:
1. Pay more each month
Should you make more than your minimum required monthly payment, you'll find yourself paying off your car in less time than the term on your loan. Of course, how much sooner depends on how much more money you decide to pay each month.
2. Consider bi-weekly payments
Another clever way to get rid of your loan as quickly as possible is to make half payments every two weeks rather than a whole payment once per month. Doing so will lead to you making 26 half-payments (or 13 whole payments) per year, an entire payment more than you are required to make.
3. Make a lump sum payment
Work performance bonuses, tax refunds, and other unexpected cash that you encounter can be a great way to make a lump sum payment towards your loan. Depending on the amount of your lump sum payment, this is likely to be the best way to pay off your car as soon as possible.
4. Refinance your auto loan
The fourth option you may consider is refinancing your existing car loan to a lower interest rate. Doing so depends on your original rate and prevailing rates at the time you want to refinance but may be a viable option.
Pros of paying off a car loan early
Regardless of the title of this post, there are many pros to paying off your auto loan as soon as you can. Among these benefits are:
A lower DTI ratio: The less debt you have, the better the debt-to-income you'll have. This will help you if you look to buy a home or otherwise borrow money again in the future.
More money to cover less expenses: With more cash flow to cover less recurring expenses, you'll open up room in your budget. You can use this money to catch up on savings, contribute more to retirement, and still have money left to spend at your discretion.
Not being underwater on your loan: Real estate professionals often talk about being underwater on a home loan. This occurs when you owe more money than your home is worth or appraised at. But this also happens with auto loans pretty regularly. Paying off your loan early may help avoid this.
Expense-free driving: If you pay off your auto loan while the car is just a couple years old, you'll likely experience a number of years of expense-free driving, other than gasoline and those routine maintenance items, like oil changes. It will likely be a number of years before costlier repairs begin to bubble up. This can be the perfect time to bolster your emergency fund, for example.
When paying off a car loan early is not worth it
Just because there can be a whole list of pros does not mean that paying off an auto loan early is always worth it. In fact, here are three situations where it may not be worth it at all:
You have a low interest rate
You're not looking to borrow any more money soon
You have a thin credit profile
Every situation is different though.
1. Your loan carries a low interest rate
Paying off your car loan early may not be the best plan for you if your existing financing carries a favorable interest rate. This was actually the catalyst for me not keeping my financing.
Given that high-yield savings accounts currently yield about 5%, mathematically speaking, you are better off just making your monthly payments if you earn more than the interest rate on your debt.
Thanks to Federal Reserve policy, this has been possible for the past year or so.
Given that I financed my car at just 2.9%, I actually come out about 2% ahead by keeping as much of my cash saved and earning the 5% instead.
Sure, there is a peace of mind component to eliminating debt and other financial professionals, Dave Ramsey included, would probably advocate that you eliminate all of your debt as quickly as possible. Ultimately, when dealing with small balances, like I have remaining on my Accord, this decision is not as critical as it is with larger assets, like houses or condos.
2. You don't need to borrow any more money
If you're not looking to buy a new home or otherwise take on any additional debt at this time, then you shouldn't necessarily be in a hurry to pay off your car.
Sure, you should still make your monthly payments in full, but preserving any extra cash that you have now in an emergency fund may make more sense now. Plus, by saving this money on the side, should your circumstances change and you find yourself applying for home or other financing, you can always make a lump sum payoff at that point.
If you're looking to buy a home or apply for any other type of financing, however, then it could be advantageous to pay off your car, since doing so will improve your debt-to-income ratio.
3. You have a thin credit profile
One more time when it is not worth parting with your auto loan quite yet is if you have a relatively thin credit file. For example, if besides your car, you only have one credit card and no mortgage, student loan, or other source of credit, paying off your car may actually hurt your credit score for a period of time.
It doesn't make sense to me, but credit agencies and lenders see this as akin to closing a credit card,
So, if you've got the means to pay off your vehicle whenever you want, it may be wise to open a new credit card for a bit before you do so. Just food for thought.
Should you pay off your car in full now?
At this point, you're wondering whether you should pay off your auto loan once and for all, particularly if you don't fit into one of the three scenarios I mentioned above. Before you go ahead and pay off your car:
Make sure the pros outweigh the cons: Is the extra cash flow you'll open up each month worth more than parting with the cash now? Are you still financially prepared in case something goes wrong around your house?
How much mental relief will you feel? Not enough personal finance experts bring emotion into the equation, even though it plays a clear role in the decision-making process. If owing any lenders money makes you anxious, then a loan payoff may be a good option.
How long you think you'll keep your vehicle: Part of my motivation to pay off my car ASAP was to experience years of payment free driving. But if you're looking to sell and switch out your vehicle in favor of a new one soon, it may not be worth it.
Ultimately, whether or not you decide to pay off your student loans early is your decision. Depending on your specific loan and financial situation, it may or may not make the most financial sense for you to do so.
Now I want to hear from you. Have you considered paying off your auto loan early? Why did you decide or decide not to do so?
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