SUMMARY: Many people are using loans to buy a car (a record number of people, actually). Before you attempt to pay off your vehicle and bring that balance to zero, consider the benefits and downsides.
Is that monthly auto loan making you anxious? Do you wish you could just pay off your car and own it outright? You’re not alone.
Auto loan rates are on the rise—up to $551 a month for more than 69 months for a new car, an increase of 10 percent over the past three years. Auto debt as a whole has marched steadily upward by 75 percent since the Great Recession ended in 2009, hitting a record $1.2 trillion in 2017.
But before you bring that balance to zero, consider the benefits and downsides.
Do it now
There are many short- and long-term perks to accelerating the pace of your car payments.
Pay less interest
When you make a monthly payment, some portions of it go toward the principal (the original amount of the loan) while others go toward the interest and fees. Some loan contracts are set up so that you will pay less interest if you quickly knock off the principal. This depends in part on the type of loan:
- A simple interest loan calculates interest based on a snapshot of the amount owed at any given moment. Pay it off fast, and the interest rate shrinks accordingly.
- A precomputed interest loan sets interest at a fixed level when you initially take out the loan. The speed at which you pay it off has a far weaker impact.
If interest payments are of primary importance, check the fine print of your loan contract to see what schedule works best.
Use the money for other things
Is your car loan competing with other expenses? Then paying it off now would allow you to put money toward your emergency fund, college savings or mortgage.
Don’t pay more than the car is worth
Depending on the term of your loan, you may end up paying more than the car’s actual value, which depreciates over time. You are then in negative equity territory, also known as being “upside down” on your loan. Pay it off faster and you significantly lower the chances of ending up in this scenario.
Not so fast ...
So, all signs point to early payment, yes? Hang on a minute. Although there is a compelling argument for quickly ditching your loan, there is also a case to be made for taking the long road.
Avoid prepayment penalties
Many loan providers would prefer that you not pay it down too fast, and will hit you with a fee if you jump ship. Depending on the size of the fee, it may still make sense to accelerate payments. Check your loan agreement before taking the leap.
Focus on more pressing debt
Odds are that your auto loan isn’t your only debt on the books. Student loans, credit cards and business loans each have their own payment schedules and APRs, some of which may be more pressing than what your car requires. It may be a more fiscally sound strategy to focus on those debts to minimize your interest payments.
Many financial gurus recommend sinking that extra money into the markets, which can bring an average, inflation-adjusted return of 7 to 8 percent. Even with inevitable downturns, these returns will likely put you ahead.
Boost your credit score
Credit reports like consistency. When you make your payments every month, it can do great things for your credit score over time. It probably won’t hurt you to pay it off quickly, but you may lose that slow, steady score improvement. If you don’t have other sources of debt, an auto loan can also help establish a solid credit history.
Stay within your budget
Although it may be tempting to tear up that auto loan contract, make sure it’s well within your means. If other debts go unpaid or you’ll struggle to pay for heat next month, remain on a slow but steady path of monthly payments.
Make the move that’s right for you
As it is for all financial decisions, debt management is a long-term process that requires patience and diligence in order to meet your obligations while also living your life. The right payment schedule may largely depend on a wide variety of factors including career prospects, homeownership, retirement planning and so much more.