Is your monthly car payment a burden to your budget? Paying off your car loan early can earn you much-needed financial freedom and save you potentially hundreds (or thousands) of dollars in would-be interest.
You can pay off your car loan early using several effective strategies, but before you do, consider any potential penalties and effects to your credit score.
- 1 The True Cost of a Car Loan
- 2 How Car Loan Interest Rates Work
- 3 Will Paying Off Your Car Loan Early Hurt Your Credit Score
- 4 5 Strategies for Paying Off Your Car Loan Early
- 5 When You Shouldn’t Pay Off Your Car Loan Early
The True Cost of a Car Loan
It’s no secret that cars are our worst big-ticket investment. Unlike houses, which typically increase in value over time, and education, which theoretically opens the door to higher earning potential, cars lose their value over time. In fact, a new car depreciates in value as soon as you drive it off the lot and will lose 20% to 30% of its value in the first year.
That’s a big deal, especially given the average cost Americans are spending on new cars in 2021. According to KBB, that hard-to-swallow number is over $40,000, up more than 4% over 2020.
That means Americans are shelling out $40,000 for a car that, in a year, will be worth anywhere from $28,000 to $32,000, representing an $8,000 to $12,000 loss.
But there’s more than just the sticker price to consider. In addition to sales tax (average of 10.12% in 2020, though it varies by state), be prepared to pay interest on your car loan. Right now, the average car loan interest rate (also referred to as APR, the annual percentage rate, though there’s a difference) is over 4%.
APR includes the interest rate, in addition to other fees, like loan origination fees or mortgage insurance. You should use the APR, not the flat interest rate, when calculating what you’re paying.
Your APR will depend on the current market and your credit score. The better your credit score, the lower your APR. If you have a weak credit score and can put off buying a car, it is advisable to build up your credit score before applying for a loan.
For 2021, rates are expected to hover between 4% and 5% for 48-month (four-year) and 60-month (five-year) loans.
Car Loan Calculator: An Example
Interest on a car loan adds up. Let’s take the $40,000 new car as an example, with a $995 dealer fee. Assume you put $2,000 down and have a tax rate of a clean 10% and an APR of 5%. You’ve agreed to pay off the loan over 60 months, or five years. (The typical car loan is anywhere from three to seven years; the shorter the loan period, the higher the monthly payment.)
In this scenario, the total cost of the vehicle after tax and dealer fees is $44,995, minus your $2,000 down payment. That leaves $42,995 to be financed. Given the 5% interest rate over 60 months, your monthly payment would be $811.37.
Over 60 months, you will end up having paid $50,682.20 (including down payment) for a car that, with taxes and dealer fees, cost just $44,995. That means, over five years, you’ve paid $5,687.20 in interest.
And let’s just ignore the fact that, due to depreciation, that car that you’ve just paid $50,000+ on is now worth just $18,752.41 (average value of 37% of original cost after five years).
Use The Penny Hoarder’s car loan calculator to figure out how much you’ll pay with real-life numbers that match your scenario.
How Car Loan Interest Rates Work
Paying off your car loan early, if you can afford it, seems like a no-brainer then. However, before you start strategizing about how to pay off your car loan ahead of schedule, do some digging to determine what kind of car loan you have.
In an ideal world, your loan will be a simple interest loan. If you have not yet purchased your car, only consider lenders that will offer you a simple interest loan. This means the interest is calculated entirely on the principal balance of the loan.
But if your lender charges precomputed interest, that means they will calculate how much you will pay in interest over the life of the loan and include that in your total balance. That means, even if you pay off your car early, the payoff quote will include all the interest you would have paid had you kept the loan open. In this case, there are absolutely no financial savings in paying your car loan off early.
One other element of your loan to research is payoff penalties. Payoff penalties are legal in 36 states and allow lenders to charge you a penalty (usually a fixed percentage of the remaining balance) for paying off your car loan early. In this case, it may be more expensive than what you would have paid in interest over the life of the car loan.
Will Paying Off Your Car Loan Early Hurt Your Credit Score
It is not likely that paying off a car loan early will hurt your credit score, but it could be keeping you from growing your credit score. Regular, on-time payments account for roughly 35% of your FICO credit score, making it the most important factor. Making monthly payments on a car loan is a great way to show lenders you are responsible with repaying your debts.
In addition, lenders like to see a nice mix of credit (mortgage, car loan and credit cards are the big three). Keeping your car loan open also helps extend the length of your credit history. If you have no other open credit (like a credit card), keeping your car loan open may be advantageous in building up your score if you eventually intend to buy a house.
5 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. Not only will you avoid spending heaps of money on interest, but it will also give you the financial freedom of hundreds of dollars back in your monthly budget.
The best advice for paying off a car loan early: treat it like a mortgage. If you are a homeowner, you have likely heard that making an extra (13th) payment toward your mortgage principal every year can shave years off your loan. If you pay even more toward the principal each year, you can easily get your 30-year mortgage down to 15 years—and you’ll be able to drop PMI (private mortgage insurance) costs much earlier.
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 a Half 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.
When You Shouldn’t Pay Off Your Car Loan Early
As we’ve seen, it doesn’t always make sense to pay off your car loan early. But there are more reasons to hold your horses than just payoff penalties and precomputed interest.
Here are some other reasons not to pay off your car loan early:
- 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 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. For most drivers, car loan APRs are not terrible. 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.
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.