Thinking about paying your car off early? While unlikely, you may notice a few points drop off your credit score afterward. However, it could save you cash in the long run, and maybe help you with future loan opportunities. When your car loan is coming to an end, many people opt to pay it off early—but what are the benefits of doing this, and are there any disadvantages?
A big amount of debt is an issue that is affecting many American families and it's leaving a big empty hole in their wallets. If you have a car that you're paying off each month, you could benefit greatly from paying that loan off early. How?
Well not only will it save you some extra money each month, but paying your loan off can help your credit scores, too. Unfortunately, this option is not available to some people, and there are things you should definitely check into with your lender before you go ahead and write a sizable check to your lien holder.
Your Credit Score and Car Loans
Paying off your auto loan earlier than scheduled makes some financial sense, and it can ease your mind – after all, you’d have one less bill to worry about each month.
If you stay current on the payments throughout the loan term, you’re likely to see an improvement in your credit score compared to when you first started the loan. This is because payment history is the most important aspect of the FICO credit scoring model.
However, there’s a category called credit mix, and it’s the reason you could see a small, temporary drop in your score after you pay off a debt. Credit mix is another aspect of your credit score, but it doesn't count for as much as your payment history.
Here’s a breakdown of the factors that make up your FICO credit score and how much of it they account for:
- Payment history: 35%
- Amounts owed: 30%
- Length of credit history: 15%
- Credit mix: 10%
- New credit: 10%
Credit mix factors in the different types of active credit you have open. Once you pay off an installment loan, it gets closed. If you didn’t have any other installment loans being reported, such as a mortgage, you may see a little drop in your score.
However, the credit mix is only 10% of your credit score. The benefits of increasing your payment history and reducing your amounts owed by paying off a car loan early far outweigh the small impact the credit mix has. Let's look at some other good reasons to pay off an auto loan early.
Benefits of Paying Off Car Loan Early
One of the biggest advantages of paying off an auto loan early is the potential savings in interest charges. Since car loans are almost always simple interest loans, you’re charged interest daily on the remaining balance of the loan. The faster you pay it off, the more money you save on interest charges.
If paying off the loan early is going to deplete your savings account, or if you’ve only got a few payments left, it may not be worth doing. You may not be saving that much, and you could only be losing a safety net. Remember that your payment history is the biggest factor when determining your credit score, not how quickly you pay it off.
However, if you have a very high interest rate, it may be in your best interest to pay that loan off as quickly as possible. If you have a lower interest rate, paying the vehicle off early may not be worth depleting your savings.
While the potential money savings are there if you decide to pay your loan off early, a completed auto loan shows lenders that you’ve paid off an entire loan successfully and that you were in it for the long haul.
Even if your credit score isn’t the best, it’s still likely to look good to a future lender and lower your risk as a borrower. Lenders like stable, responsible borrowers, and a borrower with a completed car loan on their credit reports looks great.
Calculate Paying Off Car Loan Early
When you take out a new loan – of any kind – your score will immediately drop a few points because you have now used up some of your available credit; but the sooner you pay it back, the sooner you can regain those points. This is the biggest, and really only, disadvantage of paying off your loan early.
A few points shouldn't make a huge difference if your credit score already falls in the "prime" or "super-prime" category on the FICO scoring system, but if you happen to fall in the "subprime" category it could mean the difference between an auto loan approval or a denial with a traditional lender. So, what happens if you can't do this?
Even if you have the extra money saved up to pay your loan off early, you may not be able to. In some cases, it won’t make a difference even if you do. Say what? Yes, this is true because there are some auto financing companies that will hit you with a "Rule of 78' loan.
This method pre-calculates how much interest you will pay over the life of your loan and loads the majority of that interest into the first half of your loan. Even if you decide to pay the loan off early, the payoff amount would include the remaining interest payments. If you pay it off early enough, you might be entitled to an interest rebate, but this amount would still be less than the remaining interest you'd already paid.
However, most auto loans are simple interest contracts, which are calculated based on the amount you owe (Congress passed a law in 1991 that made it illegal to apply the Rule of 78 to any loan longer than 61 months). With a simple interest loan, the interest you pay on the loan is calculated day-by-day based on the principal balance. Basically, the quicker you pay the loan off, the less interest you end up paying over the loan term. Simple interest loans rarely, if ever, come with early payment penalties. In fact, a pre-payment penalty is something you should ask about before signing any loan-related paperwork.
If you do have that rare simple interest loan with an early payment penalty, you'll need to do some number crunching before deciding to pay it off early. In particular, you need to find out if the penalty will result in you paying more out of pocket than just sticking to the payment schedule. If it does, it wouldn't be worth paying the loan off early.
How to Pay Off Car Loan Early
So, you've read through the pros and cons, looked over all of your loan paperwork, and determined that it would be beneficial to you to pay the loan off early. Now, all you need to know are the steps on how to do it. There are actually a few different tactics you can choose to take and they include:
- Round up on your monthly payment amount
- Make bi-weekly payments
- Send in just one extra payment per year
- Never skip a payment
Rounding up your payment is probably the easiest and cheapest way to get out of your loan early. You don't have to add a lot each month, but remember that the more you add to the payment amount the quicker the loan will get paid off. For example; if your car payment is $385 per month you could send in a check for $400 each month and pay your loan off almost six months early.
Making bi-weekly payments on your car loan may seem like an extra hassle to add into your life but if you can remember to do it each month, it could be a life saver. We aren't even talking about making the $380 car payment twice a month, although that would help too, we are talking about splitting that number in half. In other words, you would pay $190 twice a month and you would be paying less interest. This could help you repay your loan about 4-5 months earlier than planned.
Not everyone has the cash flow or pay schedule to make bi-weekly payments and that's okay. You can still achieve the same goal by making just one extra car payment a year. You can use your tax refund, birthday, Christmas, or any other source of extra cash to do this. Many times any extra money over the minimum required payment will be applied to your principal balance, which means that with one extra payment your principal loan balance will lower by $380.
Never skipping a payment seems like a no-brainer to anyone, but you'd be surprised by how many people take advantage of these payment programs offered by dealerships and lenders. These are often encouraged around the Holidays, but it's a ploy to tack on extra interest and payments to your loan. Think of it this way; if you skip your payment once, you need to add on one month to your loan term and possible additional interest charges. Each time you do this you have to add on another month and more interest charges, and in the end, you're not saving any money at all.
As We See It
If you have a simple interest auto loan, then it most likely does not carry any penalty for paying it off early. If you have the means to do so, you could save yourself a lot of money on interest charges in the long run and lessen your debt load quicker. If you want to save money another way, but don't have the money to make any extra payments you can apply for a loan refinance.
At Auto Credit Express, we specialize in helping car shoppers find affordable auto financing on a car that they really need, regardless of their credit – but that's not all. The dealerships in our network also can help you qualify for low auto financing rates. Get started today by filling out our online auto loan request form, and you could be experiencing savings within days.