A car is an essential part of most Americans’ lives. Without one, many can’t get groceries or commute to work.
Cars may be important but they are also expensive. Most people can’t afford or don’t want to pay cash for one. That means most prospective car owners apply for an auto loan. Almost 65% of buyers use some kind of financing when buying a car. But what if you have some extra cash? Should you use it to pay off your auto loan early? Or would it be better to spend it elsewhere?
Let’s explore the pros and cons of each option, so you can decide how best to spend your savings.
Why you should pay off your auto loan early
Why might you want to pay off your car loan early?
Improve cash flow
First, because it will improve your cash flow. Paying off your car loan means one less loan payment to make each month. That means that more of your paycheck will be yours to spend as you please, rather than getting funneled towards your vehicle.
Reduce insurance costs
Paying off your loan in full may also reduce your insurance costs. Lenders often require borrowers to carry specific kinds of insurance while their loan is still active. Once you pay off your loan, you’re free to reduce your coverage, which can also reduce its cost.
Boost your credit score
Finally, if you’re applying for another major loan, paying off your car loan can give your credit score a boost. That can help you qualify for the loan and get a lower interest rate, saving you money.
Why you shouldn’t pay off your car loan early
There are two reasons why paying off your car loan early might be a mistake.
One of the biggest downsides of paying a loan off early is the opportunity cost. In other words, spending your extra income on your loan is a waste if you could have used it to make even more money.
When you pay a loan off early, you save money by avoiding additional interest. But if you’d invested your extra cash instead, you might have seen an even greater return on investment.
The average investor’s return for the S&P 500 Index over the past 90 years was 9.7%. As such, if your loan’s interest rate is lower than that%, it could be more profitable for you to invest your extra savings, rather than making early loan payments.
Of course, investing isn’t risk-free. An investment with a 10% return could just as easily cause you to lose 10% or more of your capital. Consider how confident you feel about your investments, and whether your savings could recover from the loss. Armed with this information, decide for yourself if you’d prefer the guaranteed return of paying down your loan early, or the uncertain potential to earn even more.
Reduced cash reserves
Paying down a car loan means using some of the cash that you have on hand. When you use that money to pay the loan off, you’ll be left with less cash in your savings account. So if you run into an emergency, you can’t use that money to cover the emergency expenses.
Make sure you’ll have enough left over to handle any financial emergencies that might pop up. Don’t drain your emergency fund just to pay off your loan early — it’s not worth the risk.
Should you pay off your loan early or not?
How can you decide whether to pay your loan off early? Consider the following questions.
- Do you have enough cash on hand to pay the loan off in full? If not, how long will it take you to do so?
- Do you need access to additional cash each month, which could be provided by reducing car payment and insurance costs?
- Are you applying for another major loan, such as a mortgage? If so, does your credit score need a boost?
- Are you underwater on your loan and looking to sell the car?
If you answered yes to any or all of the questions, consider paying off your loan early.
To figure out if paying off the loan is a bad idea, ask yourself these questions.
- Is the interest rate on your loan above the inflation rate?
- Is there an investment you could make with the money that will earn you a better return?
- Will you deplete your savings to the point where you would struggle to handle a financial emergency?
If you answer yes to any of those questions, you might not want to pay the loan off early.
Paying a car loan off early does offer benefits, including the peace of mind that comes from not being in debt. But for many of us there are better ways to spend our extra income. For instance, investing your money could provide better returns and still give you access to your money in an emergency.
If you’re struggling with your car payments but aren’t willing or able to pay off the loan early, consider refinancing. Refinancing your loan with the right lender could reduce your monthly payments by lowering your interest or lengthening your loan term. Check out SuperMoney’s auto loan offer engine and see what rates you qualify for.