Paying off a car loan early may seem like a good decision, but it isn't always a wise financial move. After considering your goals, financial situation, credit rating and the terms of your loan, you may find that the long-term consequences outweigh short-term benefits. However, if it is the right choice, the options include a lump sum payoff, making biweekly payments, increasing the monthly payment and making one or two additional principal payments throughout the year.
Review the Purchase Contract
Review loan documents, especially the Truth in Lending Act Disclosure section, to see if your loan includes a prepayment penalty charge. Look for phrases such as "prepayment penalties," "precomputed loan" and "full amount of interest." Any of these phrases can mean you'll pay the full amount of interest regardless of when you satisfy the loan. In states that permit lenders to include a prepayment penalty, the CarsDirect website reports that you are more likely to see this if your loan period covers more than four years, if you have a poor credit rating or if the interest rate on the loan is higher than average.
Consider Your Credit Profile
In some cases, an early payoff can hurt rather help your credit rating because it affects your balance-to-limit ratio, also called a credit utilization ratio. This ratio compares your outstanding balances to the limits on individual credit accounts. For example, if you pay off and close a $15,000 car loan early, your personal debt load will drop by the monthly payment amount, but your available credit will drop by $15,000. If you have other outstanding debt, especially credit card debt, this will increase your balance-to-limit ratio and ultimately lower your credit score.
If you decide to proceed, consider all three options to ensure you save the most money. Although you may save the most by paying off the loan in a lump sum, most people decide between -- or combine -- available options, including increasing the monthly payment, making biweekly payments or making additional, separate principal payments. Use a payoff calculator to see which provides the most savings. Free online calculators are available on many financial planning sites and on the Bankrate and Money-Zine websites.
Initiate an Early Payoff
If you plan to make a lump sum payment, contact your lender and get the loan payoff for the date on which you expect to pay. If you plan to use any other method, contact your lender, get specific instructions and use the process each time you make a principal-only payment. Otherwise, your lender may apply your payments to the total balance, including interest. Bankrate recommends that you get principal payment instructions in writing. Once you pay the loan, the Consumerist website recommends that you keep the payoff statement forever for your own protection.
- CarsDirect: Auto Loan Prepayment Penalty Basics
- ResponsibleLending.org: Does My Loan Have a Prepayment Penalty?
- Time: 7 “Smart” Credit Tips That Aren’t
- Experian: How Utilization Rate Affects Credit Scores
- Bankrate: How to Make Principal-only Car Payments
- Consumerist: How Long Should I Hold on to My Old Bills and Other Documents?
- Bankrate: Car Early Payoff Calculator
- Bankrate: Auto Loan Calculator
- Money-Zine: Biweekly Car Loan Calculator