Should I Pay Off My Car Loan Early?
Depending on your terms, paying off your car loan early can be an excellent financial move — as long as it suits your overall budget.
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Paying off your car loan early can save you the expense of additional interest charges, but it's important to understand what else is involved. Before making that final loan payment, be aware of how it can affect your credit score, what it means for your debt-to-income ratio, and whether there are any associated penalties. Taking these and other factors into consideration can help you determine if ending your car loan early is right for you.
Pros and Cons of Ending Your Car Loan Early
There are many benefits to ending your loan early, such as freeing up room in your monthly budget and lowering your income-to-debt ratio. That said, there are some things to keep in mind when making the decision — like the potential of a financial penalty for ending your loan early.
Potential Pros:
- Freeing up room in your budget for other financial goals.
- A lower your debt-to-income ratio, possibly allowing you to qualify for other loans, such as a home mortgage.
- Allowing you to avoid getting upside-down on your auto loan.
- A move toward improved financial security.
Potential Cons:
- A fee for paying off early — if there's a penalty, you may want to weigh the fee against the interest you'll save.
- A change in your credit mix, given that paying off a loan ends those regularly scheduled on-time payments. However, this drop is typically minor and temporary as long as you keep other accounts in good standing.
- Having a better use for the money elsewhere. If you have higher-interest debt (like credit cards or certain loans), you might want to pay those off first. Or if your auto loan rate is low, you may get more value putting the money into retirement, other tax-advantaged accounts, or general investing.
Simple Interest vs. Compound Interest Car Loans
It's important to know what kind of car loan you have: simple interest or compound interest. You can generally determine this by reviewing your loan document or looking at your online loan account. If your past few statements indicate that the amount you pay in interest is declining slightly, then you most likely have a simple interest loan.
Here is how the two types of auto loans work:
- Simple interest loan: Most car loans are simple-interest loans, meaning the interest is calculated on the loan's outstanding principal balance each month. As you pay off the loan and the principal is reduced, more of your payment will go toward the principal, and the interest will be less.
- Compound interest loan: A compound interest loan typically costs more than a simple interest loan, assuming that the APRs of both loan types are the same. This is because interest is added to the balance and the future interest is calculated on that larger amount.
How Does Simple Interest Accrue on a Car Loan?
Simple interest on a car loan accrues by a small amount every day. This "daily interest rate" is determined by dividing your annual interest rate by 365, or the number of days in a year. When you make your monthly payment, the money first covers the total interest that has accumulated day by day since your last payment, while the remaining amount goes directly toward reducing your principal balance.
Because the interest charge is tied strictly to your unpaid balance — without compounding on past interest — the daily interest cost drops as your principal decreases. This means a larger portion of each subsequent payment goes to pay down the loan itself.
Paying Off a Simple Interest Car Loan Can Reduce Total Interest Paid
Car loans are structured to be repaid over a set amount of time, such as three years (36 months). Let's take an example of a three-year, $10,000 simple interest car loan at 6% to see how the interest and principal change as you make payments.
- Paying off the loan after one year instead of three saves $500 in interest.
- Paying off the loan after two years instead of three saves $174 in interest.
As you can see, those are substantial savings — money that could be put toward eliminating other debts or used as an emergency repair fund for your car.
Keep in mind that while many car loans are for three years, loan lengths of five, six, and even seven years are available. The longer the loan, the more you will pay in interest. So it's smart to frequently reassess whether you're in a place to pay off your car loan early.
Breaking Down a Loan Amortization Schedule
In a simple interest loan, your monthly payment is the same each month. But behind the scenes, how your money is applied will change. A loan amortization schedule can show the way these amounts — interest, principal, and balance — change each month as you pay off the debt.
At first, a large portion of your loan payment goes toward the interest and the remaining amount goes to the principal. Here's an example of how the loan amounts change for that $10,000, three-year car loan at 6%.
| $50 interest, $254 principal, balance $9,745 |
| $34 interest, $270 principal, balance $6,565 |
| $17 interest, $286 principal, balance $3,207 |
Looking at an amortization schedule shows that the opportunity to save money by avoiding interest is greatest at the beginning of the loan.
Strategies to Help Pay Down a Simple Interest Car Loan Faster
If you want to pay down your simple interest car loan ahead of schedule, it's important to determine how that might affect your larger financial goals. Here are some strategies to consider if you want to pay down your loan early:
- Check for penalties: Most car loans don't penalize you for paying off the loan early, but you should confirm this by looking at your contract, your account online, or calling a loan representative.
- Make extra payments: If your income fluctuates, you can make extra payments — if you make two payments in a month, it can reduce the interest you ultimately pay.
- Fit your payment to your budget and set a goal: Look at all your recurring expenses to see how much more you can pay each month. Extra payments should be marked specifically as "principal only," so the lender immediately applies it to the principal rather than assuming it is an advance payment. Once you know how much extra you can afford to pay, you can estimate how quickly the loan will be paid off. If you want additional motivation, you can check an amortization schedule and remind yourself of how much interest you'll save.
- Check interest rates: If you still have a large balance, but interest rates have dropped, you may want to consider refinancing your auto loan at a lower rate. This is particularly beneficial if your credit score has improved since you took out the initial loan. Getting a lower interest rate will reduce your monthly payments and help you pay off the total more quickly.
- Confirm your payments register: Look at your loan statements or your online account to make sure the extra money is being applied directly to the principal.
What to Check Before Paying Off Your Car Loan Early
To benefit from an early payoff, be sure to consider penalties, fees, and extra interest. Here are some questions to ask before you move forward:
- Is there a prepayment penalty? Car loans may not have a prepayment penalty, but you should verify this by contacting the lender.
- Are there related fees or extra interest? Some loans may include requirements for late fees, processing fees, or title administrative fees that could increase the payoff amount.
- How long will the payoff take to post? Consider whether you should pay a little early to avoid accruing extra daily interest.
- Have I turned off automatic payments? After payoff, remember to cancel any recurring automatic payments to prevent accidentally making an extra payment.
- Are there any remaining charges for insurance? Verify that you don't have any unbilled items tied to the loan.
- What do I do when I'm ready to make my final payment? When you're close to the end of your loan, get a payoff amount to close out the loan. Once the final payment is received, the lender will mail you your vehicle title. Congratulations! Put this important document in a safe place so you will know where it is when you want to sell or trade in the vehicle.
Frequently Asked Questions
What is a simple interest car loan?
A simple interest car loan calculates interest based on your outstanding principal balance. As you make payments and reduce the principal, the amount of interest charged decreases. Most auto loans use simple interest, and paying the loan off early can reduce the total amount of interest you pay.
Does paying a car loan off early actually save money?
With a simple interest auto loan, paying off the balance early generally reduces the amount of interest you will pay over the life of the loan. The sooner you reduce the principal, the less interest will accrue.
What are the downsides of paying off a car loan early?
You should look at your total monthly expenses to determine if this is the best choice for your financial planning. The biggest potential downside is using money that could be needed for emergencies or that could earn a higher return elsewhere.
How does an amortization schedule show interest versus principal?
An amortization schedule shows that each loan payment is divided between interest and principal. Early in the loan, a larger portion of each payment typically goes toward interest. As the principal balance declines, less interest is charged and more of each payment goes toward reducing the principal.
How can I check if my extra car payment is applied to my loan's principal?
You can check your lender's payment instructions to make sure extra payments are designated as principal-only. Then review your next loan statement or online account to confirm that the principal balance decreased by the expected amount. If you're unsure, contact the lender and ask how to make a principal-only payment.
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