Is It Worth to Pay Off Your Car Finance Early?
Time and tide wait for none, and neither should you! More so if car finance is involved. Roman Danaev, the CEO of Carplus, explains whether paying off car finance early might be in your best interest.
Is It a Good Idea to Pay Off Your Car Loan Early?
In short, yes, it is a good idea.
When the car loan has a high interest:
With a 60-, 72- or 84-month auto loan, there is a lot of interest that adds up over time. Unless it is a precomputed interest loan where is a fixed amount of interest that needs to be paid, or there is a penalty for prepayment, it makes financial sense to pay off the loan early to avoid the interest on monthly payment. An alternative way of reducing interest rates is to refinance the existing high-interest rate loan with a lower interest rate auto loan.
To improve the debt-to-income ratio:
Most lenders prefer a DTI of 43% or less, many may also prefer 31% or lower. If there are large investments in the near future, like applying for a home loan, it is best to reduce the DTI by paying off the car loan.
When there are additional open accounts:
With a long credit history with a good credit mix, deciding to pay off the car loan will cause a temporary drop in credit score. Every other charge will be unaffected.
How Can You Pay Your Car Loan Earlier?
Once the drawbacks and benefits are weighed and a decision is made to pay off the loan early, here are 6 ways to follow through.
Improve Your DTI
The DTI helps lenders estimate how much of the gross monthly income spent on debts. This is a rather simple calculation, dividing monthly debts by the gross monthly income. It is usually expressed in percentage. A low DTI is a sign of a reliable finance holder, and this is what lenders look for while deciding to lend money. A good DTI also affects the credit as the total debt owed affects the FICO score by approximately 30%.
Never Skip Payments
Missing one month of payments will drop the credit scores. If plans for future investments are in place, this will affect said future mortgage. There are lenders who will allow one or even two skipped payments, but it is not worth the dip in credit card scores.
Make More Payments a Month
This method requires an agreement regarding payment terms from the finance company to be able to pay double payments a month. This is guarantee to save money on interest, irrespective of the length of the loan. If the monthly income doesn’t cover the extra money, one piece of advice is to pick up temporary side hustles.
Rounding Up Your Payments
If this is an affordable option, rounding up payments is always a viable solution. Chalking the payment up to the nearest 50 might not be much for a month’s payment or even next month, but it most definitely will save hundreds down the line on principal interests.
Make an Extra Large Payment
There is not always extra cash lying around, but on the off chance that you received a bonus at work or you decided to sell your comic books in their mint condition and made the extra greens, make an extra-large payment with the additional money to take a chunk off your car loan. This will help in the long run, reducing the amount of interest to pay off your car.
Refinance Your Loan
Substituting your high-interest rate loan with a low interest rate is only viable if the length of the loan remains the same. It makes little car finance sense to refinance to pay less monthly, only to ultimately end up paying the same amount or more.
Paying Off Your Car Debt Early Can Hurt Your Credit?
Unless you’re in a financially comfortable position, paying off car finance early is not really possible. When major changes are made in one’s credit report history, there is a drop in credit score, even if it means paying off a loan. This dip is temporary and will rise again in a few months’ time. As long as the payments were on time, the loan will have a positive effect on your credit history for up to 10 years after the account is closed. So when does it hurt?
In case one is trying to establish credit or improve their credit score, keeping car finance open is more effective. An open car loan also diversifies the types of credit you have. Having both revolving and installment credit will help boost your credit score.
It is advised to keep the loan in the case of:
● Low-interest loan or 0% financing.
● Low emergency funds. Having 6 months’ worth of funds for emergency purposes is better than paying off your car loan.
● Near the end of the loan.
If taking ownership of the car is the goal, paying off the loan early is the way to go. This way, you will not pay more than the car’s actual worth and improves the DTI ratio. You can also choose the car insurance of your liking and get better tax returns instead of the one provided by the lender.
As tempting as this is to pay off car finance early, it also requires you to make some well-informed choices. Take the time out to weigh your options and determine the optimal strategy for yourself.