How to Pay Off Your Car Loan Early: Benefits, Strategies and Considerations
Thinking of paying off your car loan early? Doing so can free you from debt sooner, help you save on interest and add wiggle room to your budget. The current average car loan interest rate for new cars is 6.84% for new cars and 12.01% for used cars (as of the second quarter of 2024). You could save big by paying it off early. However, there are several factors worth considering before going all in on paying on your car loan ahead of time. In this guide, you’ll find the insights you need to make the most informed decision.
Why Pay Off a Car Loan Early?
Generally, the main benefits are saving money on interest and gaining financial freedom. By paying off your loan earlier than the defined terms, you can achieve improved financial security and increased cash flow.
Here’s what we mean:
- Save money on interest: Repaying your auto loan early allows you to reduce the total amount paid over the life of the loan. The interest you pay accumulates over time. If you pay it off ahead of schedule, you will minimize the amount of interest incurred and the amount paid.
- Achieve financial freedom and security: As with most loans, car loans come with a monthly payment. Depending on the terms of your loan, this monthly payment can last from one to seven years. Once you repay it, you can reallocate those funds toward your other financial goals such as building an emergency fund, saving for retirement, travel or investing. In this sense, reducing your debt load also allows you to improve your financial security. It can raise your credit score by improving your credit utilization rate.
- Increase your cash flow: As you eliminate your car payment, you’ll free up cash. This cash can be redirected as needed to pay down other debts, build your savings or simply provide more disposable income.
Strategies for Paying Off Your Car Loan Early
If you have a simple interest car loan, your credit is in good standing and your loan doesn’t have any payoff penalties, it may be wise to pay off your car loan ahead of schedule. The best advice for paying off a car loan early: Treat it like a mortgage. If you are a homeowner, you may have heard that making an extra (13th) payment toward your mortgage principal every year can shave years off your loan.
The same concept applies to auto loans. By paying more toward the principal each year, you can decrease the length of the loan and reduce overall costs. Of course, home loans tend to be much bigger than vehicle loans, so the potential to save is much larger, but the logic works the same with your car loan.
These strategies for early payoff are all effective, if done right:
1. Make One Large Extra Payment Every Year
If you can count on your grandma slipping a fat check into your Christmas card every year without fail, don’t use that money to splurge on alcoholic eggnog. (OK, maybe one bottle.) Instead, apply it directly to your car loan as a lump sum.
If you have autopay scheduled online, you can log into your account and simply arrange to make a one-time payment. If you’re old-fashioned and pay by phone or mail, simply call your lender and let them know you’d like to make an extra, one-time payment toward the principal.
Apply this logic to any unbudgeted (aka, not planned for) funds, like a bonus at work or a tax refund.
2. Make Half a Payment Every Two Weeks
Talk with your lender to see if you can switch to biweekly payments, instead of monthly. If your lender allows you to pay half of your monthly loan amount every two weeks, you will wind up making 26 half payments. Divide 26 by 2, and you get 13 full months of payments, paid over 12 months. That means, by the end of the year, you will have essentially made an extra car payment.
Just check your budget first to ensure that kind of payment plan is feasible.
3. Round Up
Rounding up to the nearest $50 or even $100, if you can swing it, is a great way to add extra money every month to the principal. For example, if your monthly payment is $337, you could round up to $350 or even $400 to essentially pay an extra $13 or $63 a month. This will wind up knocking a few months off the life of your loan.
If you have autopay scheduled, log onto your loan platform and see if you can add the additional funds toward the principal each month so you don’t even have to think about it.
4. Resist the Urge To Skip a Payment
Some lenders may let you skip one or two payments a year. So kind of them, right? Wrong. They do this knowing it will extend the life of your loan, meaning they will rake in even more of your hard-earned cash in interest fees.
Unless you fall on very hard times, fight the urge to skip a payment. You will wind up paying more in the end if you do.
5. Refinance, but Exercise Caution
If you had a poor credit score when you bought your car and opted for a seven-year loan to keep payments low, it might make sense to refinance. Perhaps you’re two years into the loan, you’ve got a higher-paying job, and your credit score is in great shape. You could potentially refinance at a lower APR and build the loan out over 36 months, saving you two years and lots of money in interest.
But borrower beware: Don’t refinance to get a lower monthly payment by extending a loan, as you will end up just paying more in interest.
Benefits of Paying Off a Car Loan Early
Repaying an auto loan early can allow you to enjoy these benefits:
- Reduced Interest Costs: This might be the most compelling reason to pay your auto loan down early. Let’s say you have an auto loan for $40,000 with an annual interest rate of 8.5% and a term of 60 months (5 years). The total interest you would pay would be $10,545.80. That’s nothing to sneeze at! By paying down your auto loan two years earlier, you would save $3,963.28 by paying $6,582.52 in interest total over those three years.
- Improved Credit Utilization Ratio: Your credit utilization ratio measures how much of your available credit you’re actively using. This ratio plays a significant role in your credit score. Once you pay off your auto loan, you’ll lower your debt load. This could lead to a better credit score which may open doors to more favorable rates and terms on future loans.
- Peace of Mind and Financial Flexibility: If the debt associated with your auto loan is weighing on you and you don’t have other high interest debt, it may be worth it to pay it down early. You can allocate that monthly payment to other purchases, needs or wants.
When Should You Pay Off Your Car Loan Early?
So, how do you decide if paying down a car loan early makes sense for your financial goals? There are three main factors to consider:
- Interest Rates: Does your auto loan have a high or low interest rate? If your car loan has a high-interest rate, paying down the principal early can work to your advantage. Here’s why: when you have a loan with a significant interest rate, a larger portion of your payment will go toward interest rather than reducing the principal balance. Early repayment generates savings on interests.
However, if you have a low interest rate, it may make more sense to focus on paying off higher interest debt (such as credit card debt) or investing in higher-yielding opportunities if applicable to your financial situation.
- Remaining Loan Balance: Next, ask yourself if you have a small or large remaining balance on your loan. If you have a small remaining balance, it may be wise to pay it off early. That way, you’ll spend less on interest and clear the loan relatively quickly.
For a large remaining balance, take care before deciding to pay off an auto loan early. Why? Well, if you have an emergency or other financial obligation pop up, you may need those funds. This doesn’t mean you shouldn’t pay off the loan early. Just make sure you have enough funds set aside for emergencies and your monthly bills.
- Current Financial Situation and Goals: Possibly the most important factor is your current financial situation and goals. If you have an emergency savings fund and no high-interest debt, it may be a strategic move to pay off your car loan early. Doing so will free up cash flow and enhance your financial stability.
On the other hand, if you have financial constraints and/or other high-interest debts, it may be wiser to address those first. For example, knock out credit card debt first to reduce the burden of that interest on your budget. Or build up your emergency funds to prepare for the unexpected and alleviate financial stress.
For there, factor in financial windfalls if you’re lucky enough to have one! If you receive a bonus, tax refund, inheritance or lottery winnings even, you may want to pay off your auto loan early (especially if you don’t have any higher interest debt and have emergency funds already).
As a bonus, be sure to factor in the potential for needing a new vehicle. If you plan on buying a new car soon, you can use the equity from your vehicle to achieve greater negotiating power for your next purchase by paying down that debt.
When You Might Avoid Paying Off Your Car Loan Early
It doesn’t always make sense to pay off your car loan early. If your auto loan is less than 61 months, you can possibly be penalized for paying down your loan early in 36 states and Washington, D.C. It can be up to 2% of the remaining loan balance. Besides these penalties, there are some other considerations to make before paying down your auto loan:
Lack of emergency savings. Bankrate reported early in 2021 that most Americans could not afford a $1,000 emergency. Just 39% have enough to cover such an unexpected expense. If you are a part of that 61% without a well-padded emergency fund, prioritize adding funds to a high-yield savings account to protect yourself and your family should the unthinkable happen. And it’s not just your family’s medical emergencies. You may need to cover a deductible on your renter’s insurance in the case of a break-in, the cost of an unexpected car repair or even a terrifying trip to the vet when your dog eats something he or she shouldn’t.
Higher-interest loans. If you have a reasonable interest rate on your car loan but are drowning in credit card debt, focus on the debt that has the highest interest rate. Credit cards historically have interest rates in the high teens, so they make the most sense to pay off first. If you are free of credit card debt but have a mortgage or student loans, compare those interest rates to that of your car loan to figure out which makes the most sense to pay down with extra funds.
Lack of credit history. If you refuse to get a credit card and don’t yet have a house, a car loan is your best bet for building your credit score. Keeping your car loan open could positively affect your credit score.
Investments. If you have some extra funds and are thinking about paying off your low-interest car loan, consider instead investing in your retirement fund or even buying a few stocks on your own. The average stock market return is about 10%. Obviously, you could wind up losing money, but in general, if you invest and hold, over time, you should expect your money to grow.
How To Decide if Paying Off Your Car Loan Early Is Right for You
Before paying off your auto loan, it’s critical to carefully weigh key factors related to your financial health. To help you decide, follow this decision-making tree.
Step 1. Assess Your Financial Situation
Do you have an emergency fund with at least 3 to 6 months of expenses?
Yes: Proceed to the next question.
No: Consider building your emergency savings first before making extra payments on the auto loan.
Do you have high-interest debt outside of your auto loan such as credit card debt or personal loans?
Yes: Pay off high-interest debt before moving on to the auto loan.
No: Proceed to the next step.
Step 2. Evaluate Loan Terms and Interest Rates
Are there prepayment penalties on your auto loan?
Yes: Calculate the penalty and determine if early repayment is still wise financially.
No: Proceed to Step 3.
Step 3. Analyze Financial Goals and Impact
Will paying off the loan early affect your ability to achieve other financial goals (e.g., saving for retirement, purchasing a home or paying down debt)?
Yes: Consider the trade-offs and whether it’s better to allocate funds to these goals instead.
No: Proceed to Step 4.
- Impact on Credit Score
Will paying off the auto loan impact your credit score?
Yes: Consider the positive impact on your credit score, especially if it will benefit future credit applications.
No: Proceed to Step 5.
- Cash Flow and Budget
Do you have enough cash flow to make extra payments without creating financial strain?
Yes: Consider paying down the loan early.
No: If paying off the loan early would strain your budget, it may be better to continue with regular payments.
Finally, it’s worthwhile to speak with a financial advisor who can provide you insights on the most beneficial avenue to take to achieve your financial goals.
Timothy Moore is a managing editor for WDW Magazine, and a freelance writer and editor covering topics on personal finance, travel, careers, education, pet care and automotive. He has worked in the field since 2012 with publications like The Penny Hoarder, Debt.com, Ladders, Glassdoor, Aol and The News Wheel.
