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Should you Pay off a Car Loan Early? It Depends. [2022]

Should you Pay off a Car Loan Early? It Depends. [2022]

Should you Pay off a Car Loan Early? It Depends. [2022]

 

Car loans can be a significant monthly payment. Being in a position to settle a loan early could mean you have more cash to spare each month and one less debt to worry about. Does settling a car loan early make sense? Not always, as much depends on your situation.

 

You would think that paying off a loan would be a universally positive thing. As usual, things aren’t quite so straightforward.

 

Did you know that paying off a car loan early can cause your credit score to drop? Sounds counter-intuitive but it’s true. That drop is only temporary and it will recover but it happens.

 

temporary drop in credit score dur to paying off debt

Source: The Finance Buff - showing a temporary drop in credit score after debt is paid off.

 

Credit scores are about how you manage debt and are not about how sensible you are with your money. Paying off early means you’re managing less debt so your score has less to work with, hence the temporary drop. Successfully balancing multiple debts is how you increase or maintain your score.

 

When does settling a car loan early make sense?

 

There are several situations where paying off your car loan early makes perfect sense. Situations such as:

 

  • Higher interest car loans: If you are paying a higher than usual interest rate, paying it off early could save a significant amount of interest over the term. If you have a significant period of time to go before the term would end naturally, paying it off early could definitely be a good idea.
  • Bad credit car loans: The same is true for bad credit car loans. If your credit score has improved and you’re not planning on getting another loan for a while, paying the loan off early could be a good financial move.
  • If you need to improve your debt-to-income ratio: If you’re looking at getting a mortgage or need to balance your debt, settling a car loan will improve the total amount you owe. This will improve the debt-to-income ratio that is used to calculate affordability for other loans.

 

Source: Mortgage Calculator

 

When does settling a car loan early not make sense?

 

happy man who paid off his car

 

You would think that paying off debts is always a positive move but there are situations where it might not make sense.

 

  • Low or zero interest car loans: If you are lucky enough to have 0% financing or a low interest rate, you may be better off leaving the loan to run its course. This is especially true if you could instead pay off more expensive debt such as credit cards.
  • When you’re using life savings: Using your life savings or rainy day fund to pay off a car loan could leave you exposed down the line. If paying off the loan leaves you little in the bank to pay for household emergencies or see you through redundancy or other situation, it might not be the best idea.
  • If you’ve almost finished the car loan: If you’re close to the end of the term there is very benefit to paying it off early. You could have a few months’ less car payments but it won’t save much in interest.

 

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