If you’re approaching the end of your car loan term, you may be thinking about paying off the note early but are wondering if doing so will hurt your credit score.
Paying off your car loan early will hurt your credit score, but only in the short term because having an open credit account that you regularly make payments on has a greater positive impact on your credit score overall. However, there are other factors to consider as well. Here’s what you need to know.
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How Paying Off Your Loan Early Impacts Your Credit
Whenever your credit history changes—such as paying off a loan—your credit score may dip slightly. If there are no defaults or bankruptcies in your credit history, this drop should be temporary, and your credit score will rebound soon.
According to Experian, a consumer credit company, your car loan remains on your credit report for up to a decade after it’s paid off. So as long as you were always on time with your payments, the loan will continue to have a positive effect on your credit history.
However, even though the paid-off car loan will ultimately help your credit score, having more opened positive-credit accounts has a greater impact than closed ones. Lenders want to see how well you are keeping up with your debt payments now, not what you have done in the past.
Furthermore, having an open car loan and making regular payments helps if you are trying to establish a credit history or improve your credit score. If you don’t have a lot of credit accounts, a car loan will pad your credit file and improve the diversity of your credit report.
Having a mix of accounts like credit cards and larger loans with fixed monthly payments can also help boost your credit score and make you more appealing to lenders.
When It Makes Sense To Pay Off Your Car Loan Early
There are times when paying off your car loan early is the right decision:
Savings
Most people decide to pay off their car loan early because of the amount of money they save. However, this only applies with a simple and not precomputed interest rate (more on that below). A simple interest rate is calculated monthly based on what you still owe, so if you pay off your loan earlier, you won’t be required to pay the interest that would have accrued over the remainder of your loan.
Helping Your Budget
You could ease the strain on your monthly budget by paying off your car loan early, giving you more money for other necessities or to stash funds away for a rainy day.
Avoid Being Underwater
If you owe more on your car than it is actually worth, it might be worth paying it off early. If you get in an accident and the car is completely wrecked, then you will have to pay back the lender the value of the vehicle plus the negative equity.
Lower Debt-to-Income Ratio
If you are applying for a mortgage loan and need to lower your debt-to-income ratio (DTI) to get approved or qualify for a lower interest rate, paying off your car loan early could improve your chances. Your DTI is the total amount you owe every month compared with your monthly income. Lenders typically like a DTI of 43% or less, but most prefer ratios below 31%.
High-interest Car Loan
If you have a car loan that matures in five years or more, you will have a lot of interest to pay over its lifespan. Paying off the loan early can reduce the total amount that comes out of your pocket. Again, it is important to make sure your lender has not included a prepayment penalty.
When Is It Better to Not Pay The Loan Early
There are some situations when you’re better not paying off your car loan early.
Prepayment penalty
In addition to considering the effect that paying off your car loan early will have on your credit score, you should also check your financing documents to see if there is a penalty for prepaying your loan. Some lenders do charge a penalty for paying off your car loan early. This would erase your hoped-for savings.
The cost of those fees may exceed the interest you’ll owe over the remaining lifespan of the loan. If so, it makes more sense to keep making your payments instead of paying off early.
Identifying Prepayment Penalties
There are a few ways that a lender imposes a prepayment penalty.
- Percentage penalties: This is the most common approach. The lender charges you a certain percentage of the loan balance remaining if you choose to pay it off early. So the amount of the penalty will depend on how long you have had the loan. The Truth in Lending Act requires that these penalties must be disclosed by the lender, so read your loan documents carefully.
- The rule of 78: This is a method used by some lenders to calculate interest charges on a loan. It requires the borrower to pay a greater portion of interest in the earlier part of a loan cycle, rather than the principal. This decreases the potential savings for you in paying off your loan early because the lender still gets paid the full amount of interest.
- Pre-computed loan: The lender calculates the entire amount of principal and interest into the loan, and the borrower agrees to pay the entire amount of principal and interest, regardless of how quickly the loan is repaid. While technically not a prepayment penalty, these kinds of loans mean you will not save any money by paying off the loan early.
Low-interest loan
On average, interest rates on auto loans tend to be lower compared to many other types of debt, especially credit cards. If you have a large card balance, paying that down makes more sense than paying off an auto loan early. And if you got really good loan terms when you bought your car, there’s really no benefit to paying it off early.
Loan is almost paid off
If you only have a few more payments to go, paying off your loan early won’t save you a significant amount of interest. In this case, it’s better to keep the loan and benefit from the boost to your credit score.
You want to sell the car
If you want to sell your car to a private party, having the title to the vehicle, which you get after you’ve paid off the loan, will make the sale easier.
You have budget constraints
You should not pay off your car loan early if it’s going to land you in a precarious financial situation. Emptying your savings account or making larger monthly payments than you can afford could make it difficult to cover unexpected expenses later.
What’s the Right Decision?
It all comes down to a mix of the topics discussed above. You should consider your credit history, credit score, how much interest you are paying verus how much you would save, your other expenses (now and in the future), if you are applying for a mortgage, and whether or not there is a prepayment penalty.
Alternatively, you can choose to refinance a high interest auto loan for one with a lower interest rate. If your credit score has improved or interest rates have plunged since you bought the car, refinancing can reduce your payments, and your credit score will continue to get a boost as you make your monthly payments on time.
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