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Can you pay off a car loan early? Is it worth it? Learn about how to know whether you can pay off your loan ahead of schedule and whether doing so is the right move for you.

If you have a car loan, you may be itching to get it paid off early so you have one less bill to manage. Not to mention, getting rid of that monthly payment has a huge appeal! There certainly are benefits that could come from paying it off.

However, paying off your loan may not be as simple as just making payments. In fact, your lender’s terms may explicitly forbid you from making payments early, and punish you for doing so with fees!

So, here’s what you need to know before you try to pay off a car loan early.

Can you pay off a car loan early?

Take a look at any financial forum and you’ll see one auto financing question dominate the threads: can you pay off a car loan early? There’s good reason for this!

Car loans may seem simple but can actually be quite nuanced, depending on your lender and the terms of your loan.

Before you whip out your checkbook to make an extra payment on your loan, consider these factors…

Look At Your Financing Terms

Before you purchase a car, it’s an excellent idea to make sure you understand the terms of the financing. However, if you are reading this article, it’s likely that ship has already sailed.

Now’s the time to pull out your financing doc and take a good look at it. Here’s what to look for.

Mention of Penalties or Fees

As strange as it sounds, there are sometimes fees that a lender will charge you if you pay off your car early. Think of this as the lender’s way of trying to recapture some of the money they would have made in interest, had you made payments for the life of the loan.

The 3 Types of Interest for Car Loans

When calculating if you can pay off a car early, it’s crucial to know the type of interest the lender used to calculate your payment:

1. Compound Interest – this is the kind of interest you pay on a credit card. It’s quite a bit rarer to have this on a car loan, but it is possible.
2. Precomputed Interest – with this type of interest, lenders will pre-calculate the amount of interest owed if you paid the car on schedule as agreed upon. This total (car price + full interest on the loan) now becomes the new amount owed, meaning even if you pay the car off early, the amount of interest owed is not reduced.
3. Simple Interest – this means that each monthly payment has a split. Part goes to your interest, and part goes to your principal. Each payment reduces the total principal due, meaning the interest is less as well. Pay off the principal in one lump sum or make a double payment, and you can save money on the interest.

Where do extra payments go?

By knowing what type of car financing you have, you should have a pretty clear idea of where extra payments will be applied first. However, it’s worth clarifying.

For example, let’s say you make your regular payment for the month, which is applied per your normal terms. Then, two weeks later, you make a second payment when you have some extra cash.

Will that extra payment go directly towards your principal? Or, will your lender apply it to the next month’s payment, split between principal and interest?

Can you afford to pay off the car loan faster?

Of course, part of deciding whether you can pay off your car early is deciding whether or not you can afford to do so. If you aren’t already doing so, now’s the time to make a budget to help you determine how much extra money you can put towards debt.

Paying Off A Car Loan Early: Pro + Cons

Just like most things in life and personal finance, there are both pros and cons you need to carefully consider when deciding whether or not to pay off your auto loan early.

Pros To Paying Off A Car Loan Early

At a glance, paying off debt like a car loan seems like a great idea. Here are a few reasons why it may be a good choice.

1. You’ll Save Money

As we learned above, it’s much harder, if not impossible, to save money on certain types of loans. However, with a simple interest loan, you could save thousands of dollars by paying off your principal early.

2. Simplify Your Monthly Expenses

For those who struggle to budget or dislike tracking expenses each month, there is certainly an appeal in simplifying expenses month to month. Not having a car payment means there’s one less bill to track and pay.

Don’t underestimate the power of financial peace!

3. You’ll Improve Your Debt to Income Ratio

If you are trying to make a major purchase such as a mortgage, refinancing a home, or applying for a large personal loan, your lender will look at how much debt you have vs how much income you make.

By paying off your car loan, you can effectively shrink your debt, making your debt to income ratio more appealing to the lender.

This one is a double-edged sword, however. While you may be able to improve your DTI ratio, you are merely trading one form of debt for another, which isn’t ideal.

Also read: Are You Ready to Buy a House?

4. Frees Up Cash for Other Purposes

Paying off your car loan early will free up extra money each month that you could put towards paying off other lower-interest debt or building your emergency fund. It also gives you extra money for investing in your retirement account, or even saving up for a fun splurge purchase!

Cons To Paying Off Your Auto Loan Faster

Most people would say that paying off a car loan early is a good thing. But, it’s not quite that simple. Here are the reasons why you may want to make another plan for your cash.

1. Can De-prioritize Building an Emergency Fund

It’s SO important to have some money saved in case of an emergency! If this year has taught me anything, it’s that being prepared pays (literally!).

If you don’t have a fully-stocked emergency fund yet, put your extra money towards building up 3-6 months of expenses rather than paying your car loan off early.

2. Could Prevent or Stall You From Paying Off More Pressing Debt

Commonly, car loans have much lower interest rates than other types of loans and debt. Average interest rates on credit cards vary slightly over time but are currently sitting at around 16%. Compare that to the average car loan interest rate of about 5%. 

If you have student loans or other debt with interest rates higher than the rate on your car loan, it makes better financial sense to pay down the debt with the higher interest rates first.

Plus, if you are a fan of The Baby Steps like I am, it’s unlikely that your car loan will be your highest debt. Start with the smaller ones, then eventually you can snowball your car payment in!

3. Your Credit Score May Take a Hit

If you only have a few more payments to make on your loan, paying it off early won’t save you much on interest. If you’re in this position, it may be better to keep your loan and benefit from the positive impact your timely payments will have on your credit score.

This may be particularly true if your car loan is the oldest – or only – active account on your credit reports.

How To Pay Off A Car Faster

Now that you know if you can pay a car loan off faster, and whether or not it makes sense for you, let’s touch on the practicals. Keep in mind that this is generic advice, and your particular situation may vary depending on the loan type you have.

One Lump Sum

If you happen to win the lottery or some other windfall (congrats, by the way!), or have a smaller balance on the loan, you may have enough money to pay the entire loan at once.

Don’t assume the amount listed on your last statement is the payoff amount, however. Contact your lender and check the exact amount you need to pay to have it considered paid in full.

Extra Payments Over Time

This is how most people pay off a car loan fast – slow and steady over time. Even if you can’t pay off the entire balance, you can apply a large payment toward your loan and still reduce the length of your loan and potentially the interest you’ll pay.

Even adding an extra $100 per car payment can really add up—just keep at it!

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Refinance

It never hurts to look at rates for refinancing your vehicle. Whether your credit score has improved or you have built a good relationship with a local bank, refinancing may be a good option, particularly if you have a high interest rate on the car.

To pay off the car loan fast, keep making your original payment (or higher!) even if your refinanced payment is less each month. Before you know it, you’ll be on your way to being car payment-free!