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Updated on Friday, March 8, 2019
The average new car loan term is nearly six years (5 years, 8 months), with used car terms right on its heels at nearly 5 years and 5 months. At the same time, those loans are becoming more expensive as car prices and interest rates creep upward.
A long-term auto loan sounds tempting — it may make the car you want seem affordable thanks to a relatively low monthly payment. But you may receive a higher APR than you would with a short-term loan and you’ll most likely pay more in interest in the long run.
There’s a way to avoid this. Paying even a small amount toward your loan principal could shorten your loan. If you can afford to pay off the entire balance, here are some points to consider.
Pros and cons of paying off a car loan early
Here are four benefits to paying off your car loan early:
- Saves money on interest
- Simplifies bill paying
- Never have to worry about owing more on the car than it’s worth
- Makes it easier to sell car
Here are four downsides to paying off your car loan early:
- May deplete your cash reserves
- You may have a lower interest rate on your car loans than on other debts
- Missed opportunity to build credit history by making car payments
- Possible prepayment penalties
How much could you save by paying your car off early?
If you are paying even moderately high interest on your car loan over an average amount of time, you might be surprised by how much that loan may cost you. For example, a borrower who buys a $30,000 car (sales tax excluded) on a 5-year loan at a 7% rate will pay an estimated $5,642 in interest. Compare that to $4,483 if they paid it off in just four years — that’s a difference of $1,159. If they take out a 3-year loan, the savings are even greater — only $3,347, with a difference of nearly $2,300 from the original 5-year loan in our example.
Even if you can’t afford the higher payments that come with a shorter-term loan or you aren’t able to pay the entire balance off right now, here are some ways you could pay off your auto loan this year.
When paying off a car loan early makes sense
You should consider paying off your car early if:
- You have no other debt besides your mortgage, and you want to be rid of monthly car payments so you can free up money for other things.
- You have a lump sum available or enough leeway in your monthly budget that you could pay off your loan without sacrificing your emergency fund or other important financial goals.
- You want your monthly expenses to be lower by a certain point; for example, before you expand your family or by retirement age.
- You need to improve your debt-to-income ratio; for example, if you are planning to apply for a mortgage.
- Making a goal to pay off your car debt will motivate you to take charge of your money and start reaching toward other financial goals.
When paying off a car loan early might not be a good idea
Consider sticking to your original payment plan if:
- You have insufficient backup cash for emergencies. “The first thing you have to look at is if you have an emergency savings fund built up, with a minimum three months in living expenses,” said Kris Alban, executive vice president of San Diego financial wellness company iGrad. “You have to have that emergency savings before you start to look for areas to cut down on debt.”
- You are paying higher interest rates elsewhere. As secured loans, some car loans have low interest rates. “If it’s a low interest rate, under 5 percent, I would look to do other things with that money,” said Alban. “You’re probably better off using that money to invest in your retirement.”
- You want to build your credit report by making car payments. Making car payments can help your credit report in two ways. It adds to your history of on-time payments, and improves what FICO calls your credit mix — your history of having credit cards, installment loans, and other accounts. “People think more than one credit card will fix their credit mix, but no,” said Alban. It especially helps to have more than one type of credit if you don’t have much else on your report.
- Your initial car loan period is relatively short. If you signed up for a three-year payment plan when you purchased your car, for example, you may be perfectly happy paying it off as planned. You’re already minimizing your total interest expense, and you may be able to drive your car for years after you’ve forgotten what car payments are like.
- Your car loan agreement includes prepayment penalties. “Always check the prepayment terms for your loan,” said Alban. “Prepayment penalties used to be a lot more common.” If you do make extra payments, be sure your lender applies them to the principal amount of the loan.
More ways to replace your car loan
Paying off your car loan isn’t the only way to save on interest expense. If you have a high-interest car loan, instead of paying off your loan, consider one of these options:
- Draw on a low-interest line of credit. If you have a home equity loan with a lower interest rate than your car loan, for example, you may want to take cash from your line of credit to pay off your auto loan. Be aware, however, that you can generally no longer deduct interest from a home equity line of credit on your tax return, unless you use the proceeds to buy, build, or substantially improve your home.
- Borrow from a relative or friend., If you’re paying 6 percent, say, on your auto loan, and your mom gets less than one percent on her savings account, perhaps you can work out a deal. You can borrow from her and pay her a better rate of return than she is getting at the bank. You should only borrow from relatives and friends if you have a solid relationship, and if you are not endangering their financial well-being if you should lose your job or something else goes wrong. Be sure to put any financial agreements in writing.
- Refinance your car. This can be especially helpful if you have improved your credit since you purchased your car, and you now qualify for better rates, or if interest rates in general have gone down. Consider starting your auto refinance shopping with LendingTree, where there are dozens of lenders waiting to compete for your business.
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