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Should you pay off your car loan early? This question may sound like a no-brainer, but the answer isn't as simple as it seems. In some cases, paying off your car loan early can negatively affect your credit score.
Paying off your car loan early can hurt your credit because open positive accounts have a greater impact on your credit score than closed accounts—but there are other factors to consider too. Before you rush to write that last check to your lender, here's what you need to know.
How Paying Off Your Car Debt Early Can Hurt Your Credit
Whenever you make a major change to your credit history—including paying off a loan—your credit score may drop slightly. If you don't have any negative issues in your credit history, this drop should be temporary; your credit scores will rise again in a few months. After it's paid off and the account is closed, your car loan will remain on your credit report for up to 10 years, and as long as you always made your payments on time, the loan will continue to have a positive effect on your credit history.
So what's the problem with paying off your car loan early? Even though closed accounts still affect your credit score, open positive credit accounts have more of an impact than closed ones. That's because open accounts show lenders how well you're managing your credit right now—not in the past.
If you're trying to establish credit or improve your credit score, keeping a car loan open could be more helpful than paying it off. For example, if you have a thin credit file (meaning you only have a few credit accounts), a car loan will add to the number of accounts you have, helping to build your credit history. A car loan also helps to improve your credit mix by diversifying the types of credit you have. Having both revolving credit (such as credit cards that allow you to carry a balance) and installment credit (loans with a fixed monthly payment) can improve your credit mix, which can help boost your credit score.
When Is It a Good Idea to Pay Off Your Car Loan Early?
There are some situations when paying off your car loan early may be a smart move:
- If you have a high interest car loan: If you have a 60-, 72- or even 84-month auto loan, you'll be paying a lot of interest over the life of your loan. Paying off the loan early can reduce the total interest you pay. Before doing so, make sure your lender doesn't charge a prepayment penalty for paying off the loan early. (If you have a precomputed interest loan, the total amount of interest you'll pay was calculated and fixed at the start of the loan, so even if you pay off the loan early, you still have to pay that precomputed interest.)Refinancing a high interest auto loan for one with a lower interest rate is an alternative to paying it off early. If your credit score has improved or interest rates have dropped substantially since you bought the car, refinancing can reduce your payments, and your credit score can still benefit if you make those payments on time.
- When you need to improve your debt-to-income ratio: Some lenders consider your debt-to-income (DTI) ratio—the total amount you owe every month compared with the total amount you earn—when deciding whether to offer you credit. In general, lenders like to see a DTI of 43% or less, but many lenders prefer ratios below 31%. (Learn more about calculating your debt-to-income ratio.) If you're planning to apply for a home mortgage in the near future, but your DTI is higher than lenders like to see, paying off your car loan early could boost your chances of qualifying for a mortgage.
- When you have additional open accounts: Do you have lots of other credit accounts and a good credit mix (such as a mortgage, a student loan and several credit cards)? If you have a long credit history with diverse types of credit, paying off your car loan early should only cause a temporary dip in your credit score.
When Is It Better to Keep the Loan?
Here are some situations when you're better off keeping your car loan:
- When you have a low interest loan or 0% financing: On average, interest on car loans is lower than on many other types of debt. For example, current credit card interest rates average about 17.75%, while car loan interest rates average about 4.75%. If you're carrying credit card balances, paying them down makes more financial sense than paying off a car loan early. Were you lucky enough to get a 0% financing deal when you bought your car? Then there's really no benefit to paying the loan off early. If you've got extra cash burning a hole in your pocket and no other debt, invest it (or save it for a down payment on your next car).
- When you don't have an emergency fund: Experts recommend keeping three to six months' worth of expenses in an emergency fund in case you lose your job or are hit with unexpected expenses. If you don't yet have an emergency fund, any extra cash should go towards establishing one, rather than paying off your car loan early.
- When you're close to the end of the loan: If you only have a few more loan payments to go, paying off your car loan early won't save you a significant amount of interest. In this case, it's better to keep the loan, make those remaining payments on time, and benefit from the positive effect this will have on your credit score. (The only exception: If you want to sell your car to a private party, having title to the vehicle will make it easier to do so.)
To Pay or Not to Pay?
Should you pay off your car loan early? To make the right decision, consider your credit history, credit score and credit mix; the interest rate on the car loan and potential savings; and whether the money you'd spend paying off the car loan in a lump sum would be better spent elsewhere, such as paying down high interest credit card balances or building an emergency fund. If you're not sure what your credit score is, get a free credit report to check your credit history, credit score and credit mix.