You have had your car loan for a couple years now and tax season is right around the corner with a refund. A refund that could pay off the balance of your car loan and eliminate that annoying monthly payment.
But wait…you may not want to move to quick. Sometimes continuing to pay the car loan is a good thing. Let me explain.
Depending on your credit situation, paying off your car early could have serious consequences for your credit score and financial health. Or, it could be the best thing ever. If you’re able to completely pay off your car, you absolutely should, regardless of the minor credit hit.
Here are some things to consider when thinking about paying off your car loan now or later.
Your Credit Score
Let’s say you’ve had your car loan for four years and you’ve been consistently making on-time payments. The amount of time you’ve had the loan, plus your solid payment history, are huge factors in keeping your credit score high and healthy.
Paying off your car loan before the term ends could drop your score by a few points.
That’s because paying your car off early is like closing an account, which could affect your score negatively. Open accounts, on the other hand, typically boost your score.
Lenders like it when consumers can demonstrate their ability to pay down their debts over a sustained period of time. It shows you’re financially responsible and capable of handling debt over long stretches. That enhances their perception of you as a consumer, which can help boost your credit score and motivate them to give you better rates when you apply for another type of loan.
Still, closed car loans stay on your credit report for about a decade and can have a positive effect on your credit score as long as you made your payments on time.
Your debt diversity
A car loan adds to the mix of credit types that appear on your credit report, another important factor in determining your credit score.
For example, you may only have a credit card and car loan in your name. Those are two very different types of debt.
Credit cards are a type of revolving debt, which means you get a credit limit and you’re free to spend any amount on the card until you reach that limit. Once you repay your balance, the card resets and the money you repaid becomes available again.
A car loan, however, is a type of installment debt. You repay the loan in fixed payments each month, contributing a certain amount to the principal and interest until the debt is completely repaid. And once it’s paid off, it’s paid off. No more payments and no more money to borrow on that particular loan.
It looks good to lenders if you have both types of debt on your credit report. You get even more points if you eventually toss in a mortgage.
How much you pay in interest each month can easily motivate you to pay off your car sooner rather than later.
Let’s say you take out a $25,000 auto loan with a six-year term and 5% interest rate. You’ll end up paying close to $4,000 in interest alone.
Paying your loan off early can save you from paying all that interest. For example, if you pay off your auto loan just a year earlier, you’d pay $3,448 in interest, saving you about $600. That may not seem like a huge savings, but it does free up your expenses.
Your debt load
Although a variety of credit types looks great on your credit report, there is such a thing as too much debt. If you’re juggling way too much, you could bring more harm than good to your credit score and wind up stuck in a financial bind.
If you already have a good mix of credit and a long credit history, then paying your car off should only cause a temporary dip in your credit score. As time goes on and you continue making on-time payments on your other accounts, your score will rise again.
Also, keep in mind your debt-to-income ratio, an important measure of how much debt you have in relation to how much money you earn. Lenders evaluate your DTI to determine whether they’ll let you borrow money for major purchases, like a home or car. Your DTI gauges whether you have enough money to afford those payments.
If a lender feels your debt substantially outweighs your income, they may be reluctant to lend you money. That, or they may give you a high interest rate, which equates to high monthly payments. If you plan to apply for a home mortgage, paying off your car early could increase your chances of qualifying for a mortgage and snagging a better rate.
Your credit cards
Why should you think about credit cards if you’re considering paying off your car? Well, credit cards typically have higher interest rates than auto loans.
The national average for auto interest rates right now is about 4.2%. Compare that with the average credit card rates, which, depending on the kind of credit card you get, could range from 16 to 20%.
If you have high-interest credit cards with outstanding balances, you might want to attack those first if you’re looking to lower your debt. Apply the money you would’ve spent paying your car off to paying down your credit cards which, if left unpaid, accrue a lot more interest and can do more harm to your credit score.
So, should you or shouldn’t you?
Deciding whether to pay your car off now or wait a little longer really depends on how you feel about your credit. If you need to establish a credit history or boost your score, you may want to consider keeping your auto loan around a bit longer. But, if your credit’s in good shape, you have the means at your disposal and need to offload some debt, then pay off the car and enjoy one less payment every month.