Most people think that paying off an auto loan faster can only bring benefits. In fact, there are situations where choosing to pay off your car early can be a bad idea, or at least not beneficial.
Before you pay off your car early, see if any of these situations apply to you.
1. You Have a Simple Add-On Interest Loan
Auto loans come in all shapes and sizes. There can be different rules regarding the processing of interest, and not all approaches work in your favor.
If you have a simple add-on interest loan (not a simple interest loan), paying off your car early won’t reduce how much you pay. Instead of calculating interest each month, add-on loans calculate it for the life of the loan right at the beginning. Then, they add the interest to the loan total, creating monthly payments from there.
Even if you pay this loan off early, you still pay the interest associated with the entire original term. That means you don’t save money when you pay off your car early.
2. There’s an Early Pay Off Penalty
Some lenders assign early pay off penalties to car loans. This means, if you pay off your car early, you’ll owe them an additional fee.
This approach lets lenders receive compensation for the interest you won’t be paying when you do an early payoff. In some cases, depending on what you owe and the remaining length of the term, you can actually end up paying more with the penalty than you would just paying the interest.
To see if this applies to you, you need to review your loan agreement. That way, you’ll know if there’s a penalty before you pay off your car early. Then, you can see if the paying the penalty saves you money in the long run in comparison to the interest payments.
3.You Have Higher Interest Debts
While car payments can be large, they typically have lower interest rates than some other debts. For example, your car loan may have a 5 percent interest rate while your credit card is at 15 percent.
If you have higher interest debts, paying those off first might be a better option. This is especially true if you have a large balance on a high-interest debt. The approach lets you reduce the total amount of money going to interest more quickly, allowing your hard-earned dollars to save you more in the long run.
4. Investing the Money Yields a Better Return
Similarly, if you have a low-interest car loan, you might want to invest the pay-off money instead. For example, if your loan has an interest rate of 5 percent, but you could earn an 8 percent return on an investment, investing the money lets you come out ahead.
5. It Damages Your Credit
In some cases, paying off your car early can damage your credit score.
Credit score calculations are complex. One factor of your score is the diversification of your debt, or how your debt is split between installment and revolving accounts.
If you pay off your car early, your percentage of revolving and installment debt shifts. In some cases, this won’t have a negative impact. But, in others, it will.
Your unique situation dictates whether your score will go up or down. However, it’s important to know that it’s possible the impact will be negative.
Is There Ever a Good Reason to Pay Off Your Car Early?
Yes, there are good reasons to pay off your car early. For example, if you have a high-interest loan, then paying it off could be smart. Just make sure that the situations above don’t apply to you before making that decision.
Agree with our list? Share your thoughts in the comments below!
Ready for more great articles from Newlyweds on a Budget? Give these a try:
- One Couple, One Car: 5 Benefits of Sharing a Vehicle
- 5 Steps to Refinancing Your Car Loan
- Top 3 Tips on Buying Used Cars for Families