If you pay off your car loan early, you can save money on the total cost of the loan as you reduce the amount of interest you pay. However, there are also downsides to consider with paying off your loan early, such as that you may have less cash to put toward other debt or investments and may have to pay a prepayment penalty.
Key Takeaways
- Paying off a car loan early can save you money in interest in the long term.
- When you pay off a car loan early, you also reduce the total amount of money that you owe, which may boost your credit score.
- Some lenders charge prepayment penalties that can offset what you would save in interest.
- Paying off a car loan early can cause your credit score to temporarily decline if your car loan was your only installment loan.
Why Paying Off Your Car Impacts Your Credit Score
Many people use car loans to finance new cars, so they are paying for the cost of the car and the cost of the loan through interest. In recent years, car loan terms have been getting longer so that borrowers can better afford the monthly payments. Car loans can have terms as long as 96 months, but the average repayment term is 69 months.
In some cases, borrowers find themselves in a position to pay off their car loan early. Paying off your car loan early can save you money, and it can also impact your credit score. Whether it makes sense to pay off your car loan early depends on the terms of your loan and your personal financial situation.
Your credit score is calculated by factoring in: your payment history, the length of your credit history, the amounts owed, your credit mix, and whether you’ve applied for new credit. Let’s look in more detail about how paying off a car loan will affect each component of your credit score.
- Payment history: If you have made all your payments on time, closing a car loan early will likely have little impact on your credit history. It can ensure that you will not be at risk for making any late payments in the future. In fact, if you have no negative payments, your positive payment history can remain on your credit report for up to 10 years. Your payment history accounts for about 35% of your FICO credit score.
- Length of credit history: If your car loan is among the first loans you have had, closing the loan could potentially negatively affect your credit score. However, the effect will likely be minimal. The length of your credit history accounts for about 15% of your FICO credit score.
- Amounts owed: Paying off your car loan early can have a significant positive impact on your credit score by reducing the total amount of debt you carry. The amounts owed accounts for about 30% of your FICO credit score.
- Credit mix: If a car loan is the only fixed-rate installment loan that you carry, it could potentially have a minor negative impact on your credit score if you close the loan. Your credit mix accounts for about 10% of your FICO credit score.
- New credit: Closing a car loan early will have no impact on whether or not you’ve applied for new credit. New credit accounts for 10% of your FICO credit score.
Note
Generally, any decrease in your credit score as a result of paying down debt is temporary. But if you make all of your other payments on time and keep your credit card balances low, your credit score should recover within a few months.
What to Consider Before Paying Off Your Car Loan Early
Before paying off your car loan early, weigh the advantages of saving money with potential negative consequences like paying a prepayment penalty or not having extra money to put toward other goals. Here are some questions to consider.
Does the Lender Charge Prepayment Penalties?
Some lenders charge prepayment penalties. Typically, paying off a loan early helps you save money, but prepayment penalties could cut into your savings. Prepayment penalties are usually a percentage of the loan amount, such as 1% of the original loan amount if the loan is paid off before its scheduled payoff date. For example, if you had a $10,000 loan and your lender charged a prepayment penalty of 1%, you would pay $100 in a prepayment penalty.
In many cases, the savings you would get from paying off your loan early would outweigh the prepayment penalty. Calculate your prepayment costs and potential interest savings for your situation.
If you aren’t sure whether your lender charges a prepayment penalty, review your loan agreement and Truth in Lending Disclosure form or contact your lender’s customer service department.
Do You Have Other Debt with Higher Interest Rates?
Paying down debt is usually a good idea, but in some cases, it may make more sense to target other debt with higher interest before paying off a car loan early. Car loans typically have lower interest rates than, for example, credit cards or personal loans. So paying those debts off first could save you significantly more money than paying off a car loan early.
Do You Have an Emergency Fund?
Before putting extra money toward your debt, consider building an emergency fund. Many financial experts recommend having at least three months’ worth of necessary expenses saved to help you avoid financial turmoil in the event of unexpected expenses like medical bills.
Pros and Cons of Paying Off a Car Loan Early
Pros
You could save money in interest.
You would improve your debt-to-income (DTI) ratio.
You would have more money for other goals like investing or saving.
Cons
You may face prepayment penalties.
Your credit score may temporarily decrease.
You may have less money for other goals like investing.
Examples of Paying Off a Car Loan Early
Here are several scenarios in which a borrower may pay off a car loan early. With these examples, you can better understand the pros and cons of early repayment of your car loan so you can decide if it’s right for you.
- You bought a car from a buy-here, pay-here dealer: Buy-here, pay-here dealers charge much higher annual percentage rates (APRs) than traditional lenders. According to the Consumer Financial Protection Bureau (CFPB), typical buy-here, pay-here rates can be 15% to 20%. With such a high rate, paying off the loan as quickly as possible can help you save a significant amount of money.
- You had poor credit when you bought the car: Borrowers with poor or fair credit tend to pay much higher rates than those with very good to excellent credit. If you bought a car with less-than-perfect credit and have improved your score since then, you can likely save money by paying off the loan faster or by refinancing it.
- You have a co-signer: If you had a friend or relative co-sign your car loan when you took it out, paying it off ahead of its scheduled payoff date will free your co-signer from their responsibility for the loan.
If you have a car loan with a high interest rate but can’t pay it off faster, consider auto loan refinancing. You may qualify for a lower rate that allows you to save a substantial amount of money and allows you to pay the loan off sooner.
How Long Does a Car Loan Stay on a Credit Report?
If your account is paid in full with no negative account history, the closed account will remain on your credit report for 10 years from the paid date. If you had late payments before it was paid off, it will remain on your credit report for seven years after the original delinquency date.
How Long Does It Take for Your Credit Score to Go Up After Paying Off a Car?
Although your score may decrease after paying off a car loan, the impact is usually temporary. You should see your credit score improve within one or two months if you have no other negative factors affecting it.
How Much Do You Save on Interest When You Pay Off a Car Loan Early?
How much you can save by paying off a car loan early depends on the APR on the loan and the length of time remaining on your debt. You can use an auto loan calculator to estimate how much interest you’ll pay over the life of your car loan based on when you pay off your particular loan.
Can Paying Off a Car Loan Early Have Other Cost Benefits?
Yes, potentially. If the car isn’t new or isn’t worth a significant sum of money, you could lower the insurance cost by either raising the deductible or dropping the collision coverage entirely. When there is a lien on the title, the lender requires full insurance coverage, but once your loan is paid off, then that requirement is lifted.
Does Refinancing a Car Hurt Your Credit?
Refinancing an auto loan can cause a minor temporary decrease in your credit score. When you apply for a loan, it will show up as a new credit inquiry, and it can affect your debt-to-income (DTI) ratio. Lenders view applications for new credit as a sign of risk. However, if you make on-time payments, refinancing to a better rate can save you money in the long run.
The Bottom Line
Paying off a car loan early can be a good way to save money and eliminate financial stress, but, depending on your situation, it may not be the best decision. In some cases, it may be better to put your money toward other financial goals, such as paying down higher-interest debt or building an emergency fund.
