By Phil West, WCI Contributor
While a car is a necessity for many Americans, it’s not the best or smartest investment—especially the way that far too many Americans do it. If you’re wondering, “Should I pay off my car loan early?” it’s likely that you should (though there are some caveats that we’ll cover here).
As we’ve pointed out previously when discussing how to buy a car, the best car loan is no car loan at all. In that article, Dr. Jim Dahle wrote, “If you only make $50,000 (the average American household income) and are losing $5,000 a year in auto loan interest, repairs, and car depreciation, then it becomes very difficult to get ahead.” Even if you make more than that, using your cash on hand after saving up for a few months to buy a car means the money that would have gone to a loan can go to something else (like to paying off student loans or filling your retirement accounts).
But if you’re in the position where you’re paying month-to-month on a car loan, you’re probably better off in the long run to get the car paid off as soon as you can—and then don’t repeat the same mistake next time you buy a car.
Do I Save Money By Paying Off My Car Early?
Do make sure to read the fine print on your loan before you make plans to pay it off. The reason is that it's possible that your loan contract could force you to cough up prepayment fees, meaning that if, for instance, you pay off the entirety of a 36-month loan in only 12 months, you could actually be penalized by your provider for doing so.
As Forbes noted, “Keep in mind that many contracts are in place to avoid buyers paying their car loan off incredibly early, like six months after buying. If you pay yours off two years into your loan, for example, you might not face any fees. But you’ll need to read over your car loan contract or contact your lender to see if this applies to your case.”
More information here:
Will Paying Off My Car Hurt My Credit?
There’s also the possibility, as Bankrate points out, that paying off a car loan early can drop your credit score by a few points. Depending on where your credit score is—and that’s something you should be mindful to monitor—a drop of just a few points could impact a bigger purchase. However, it could just as easily raise your credit score as it decreases your debt.
You also want to consider the type of debt you do have as you’re considering how quickly to pay off your car loan. If you have a car loan that’s at 3% interest and a credit card that’s at 12% interest, it’s pretty easy to determine what debt you should pay down first. While the principal on a new car will likely be more than whatever other lines of credit you might have, you might be losing more in the long run on interest from a credit card than a car loan.
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How Does Paying Off My Car Affect My Debt-to-Income Ratio?
Because that principal can be so significant, paying off a car loan can help with your debt-to-income ratio. As Forbes writes, “The lower your DTI, the better you look to future creditors and lenders.”
Even if you’re following the advice Dave Ramsey gives that the value of all the things you own with motors (cars, boats, planes, etc.) should be less than 50% of your annual gross income, a car payment can be a substantial percentage of your monthly outlay. Freeing yourself from a monthly car payment allows you to tackle other debts and improve your overall DTI.
More information here:
But What If I’m Planning to Sell My Car?
You can also make your car a more valuable asset by not having it tethered to debt. If the Kelley Blue Book value of your car is $15,000 but you still owe $8,000 on it, your car will really only get you $7,000 if you sell it. If you’re looking to sell your car in the next year—and maybe replace it with a less expensive car paid for with cash—you could come out ahead if you can offset further depreciation with what you save on interest.
You do want to consider, though, that the cost of a car is not just your car payment. There’s insurance, there’s maintenance, and there’s gas to keep it moving from point A to point B. But it’s far more likely that a car paid in full will cost you less overall than a car with a loan attached to it—even with the occasional expense of a repair.
And keep in mind what Dahle once wrote when answering a question from a doctor asking if he should pay off a $12,000 car loan: “Quit buying cars on credit. Pay this one off ASAP and then keep putting the payments into a ‘car account.' When it comes time to buy your next one, you can use cash. There's no reason for anyone, much less a physician, to buy a car on credit.”
Or you can listen directly to him on the matter.
What If I Can Outinvest My Interest Rate?
Lots of people use borrowed money to buy cars (and then drag those loans out as long as possible) because they feel they can earn a higher rate of return with their investments than they are paying on the auto loan. Or perhaps when inflation is high, they feel like they're paying off the car with depreciating dollars. While the math is incontrovertible (borrowing at 2% and earning at 8% is a winning strategy), this approach fails to account for both risk (investments that pay 8% are rarely as risk-free as paying off a car loan) and behavior (most people don't invest the difference; they spend it on something else.)
Tread carefully if you head down this path. Ask yourself, “Do I really need this additional leverage to reach my financial goals?” The answer with a car loan is almost surely no. What's next, a loan on your dishwasher?
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