Canadians owe an average of around $20,000 on their vehicles. By paying off your auto loan early, you can free up a significant amount of money each month.
If you find that you have the money available to pay off your car loan ahead of time, however, you shouldn’t jump the gun. There’s more to paying off a car loan early than meets the eye, so you need to make sure that you know what to expect.
If you want to know whether paying off your car loan early will affect your credit score, read on. This guide will tell you everything that you need to know.
Does Paying Off a Car Loan Early Affect Your Credit Score?
When you pay off a car loan early, the truth is that it could potentially hurt your credit. Paying off a car loan early may make your credit score drop by several points. However, in many cases, the drop will be temporary.
There are many reasons that your credit score may go down after the account is closed. Once the account is closed, it will no longer have a positive effect on growing your credit and improving your payment history. Active accounts tend to do more for your credit than closed accounts do.
If you’re working on improving your credit, you might be better off keeping the account open rather than closing it. However, the choice you make will depend on your credit goals.
Whether you have a loan for a new or used car, there are a lot of factors to take into consideration when deciding whether to pay it off early. Below we’ll expand on the details and help you make a decision about whether you should pay off your car loan.
Does Paying Off a Car Loan Early Affect Your Credit Score?
So how does paying off your auto loan ahead of time affect your credit score? Here are some of the ways that you should know about.
Affects Your Payment History
Paying off your car loan early will have a big impact on your payment history.
Making payments on your debts month after month has a positive impact on your credit score. When you close your car loan account, however, you’ll no longer be making these regular payments.
The closed auto loan account will remain on your account for as long as 10 years after closing it, but you’ll no longer be making payments. This can cause your score to stop going up as steadily.
Changes the Length of Your Credit History
You should realize that the length of your credit history and the age of the accounts contribute to your credit score. You’ll want to take the average age of your accounts into consideration when paying off your car loan.
Your auto loan can stay on your credit report for as long as 10 years after paying it off. However, when you close an account and finish paying off your vehicle, the average age of your accounts may go down. This will partially depend on how long you’ve had it and how many other accounts you have.
Changes Your Credit Utilization
Paying off a car loan can also impact your credit score by changing your credit utilization.
While revolving lines of credit tend to play a bigger role in credit utilization ratios, loans have an effect as well. The balance of your loan counts as part of the credit that’s available to you. If you pay the balance off, then this number will no longer matter and you’ll be relying on only your other accounts instead.
Alters the Mix of Your Credit Accounts
It’s generally good to have a mix of different types of accounts that count towards your credit score.
This includes revolving accounts such as credit cards as well as installment accounts such as car loans. If your car loan is the only installment account that you have, then paying it off and closing it may reduce your credit score a bit.
The smaller number of accounts you have, the more chance there is that closing the account could have a negative impact.
What Else Should You Think About When Paying an Auto Loan Early?
Aside from the impact on your credit score, there are some other things to consider when paying a car loan early as well. Here’s what you should keep in mind.
Prepayment Penalty
Before paying off your car loan, you should check to see whether there are any prepayment penalties. A prepayment penalty is a fee that you’ll owe if you decide to pay off the loan ahead of time.
You’ll want to check your car loan terms to find out exactly what you’ll owe if anything. It still may make sense to go ahead and pay your car loan off even if there’s a prepayment penalty. However, you’ll want to do some calculations and weigh out the pros and cons carefully when making your decision.
Monthly Budget
You should also think about your monthly budget when deciding whether to pay off a car loan ahead of time.
If you’re going to be too tight on money to handle other important expenses by paying off your loan early, you might want to make the choice to continue paying the smaller installment payments each month instead. This can make your monthly budget a lot more manageable overall.
Paying Off Other Debt
When paying off debts that you have, it’s a good idea to target the most expensive accounts first. If you have other loans or if you have credit cards to pay off, it’s a good idea to determine what the annual percentage rate (APR) is for each of them.
It’s typically a good idea to pay off accounts with higher APRs first so that you can avoid paying as much interest overall.
When Should You Pay Off Your Car Loan Early?
So when exactly is it worth paying off your loans early? Here are some signs you should look for when deciding whether early payment is a good idea.
Your Debt-to-Income Needs Improvement
Particularly when you’re getting ready to buy a home, it’s important to put effort into improving your debt-to-income (DTI) ratio. Your DTI ratio is the amount of money that you owe each month contrasted with the amount that you make each month.
Mortgage lenders will check your DTI when you’re applying for a mortgage. If it’s too high, you may not be able to get a mortgage. Ideally, your ratio should be under 36% when looking for a mortgage.
Getting rid of some of your monthly debt obligations, such as a car payment, can allow you to improve your DTI and have a better chance of getting approved.
You're Paying a Lot of Interest on Your Car Loan
One of the clearest signs that you should pay off your car loan is if it’s high in interest.
If the car loan has an APR that is on the higher side and the length of the loan is as long as 60 months or more, you’ll end up paying a lot of interest overall. In these cases, it might be best to pay the car loan off in full rather than continue paying month after month.
As an alternative to this, you might also want to consider refinancing the car loan and getting a lower interest rate instead.
You Have a Good Credit Mix
As mentioned above, having a mix of both credit and installment accounts can have a positive impact on your credit score. If you have only a single installment account then closing it could negatively impact your credit.
On the other hand, if you already have a lot of variety in your credit accounts, then this might not be much of an issue. In this case, you might want to go ahead and pay off your car loan ahead of time.
While you may still experience a temporary decrease in your credit score, it likely won’t make a significant impact on your score overall.
You're At Risking of Having Negative Equity
The longer you take to pay off your car loan and the more interest you pay overall, the bigger chance there will be that you’ll end up “upside-down” or “underwater” on your loan.
This happens when you end up with negative equity in your car because of the rate of depreciation on your vehicle. At this point, you’ll owe more money on your vehicle than it’s actually worth.
By paying off your car loan early, you can avoid this and ensure that you don’t get negative equity in your vehicle.
You Need More Monthly Funds
One of the benefits of going ahead and paying off your auto loan early is that you’ll have extra money available to use every month. This money could be put to good use in other ways if you’re not paying for a car payment.
Having extra funds available to you and your family could allow you to pay off credit cards and other loans or save up for emergencies.
When Should You Consider Keeping the Car Loan?
While there are many benefits of paying off your car loan early, there are circumstances where it makes more sense to keep paying it off normally. Here are some reasons why it may be better to keep the loan.
Your Car Loan's Interest Rate Is Very Low
If you have a car loan that has a particularly low amount of interest or 0% interest, then it might be best to keep making payments on it instead of paying it off.
This is particularly true if you have other types of debt, such as credit card debt. While car loan interest rates are often under 5%, credit card interest rates are often 18% or more.
If you have credit cards or higher interest debts along with your car loan, then you might want to prioritize those debts instead, especially if your car loan requires 0% interest.
You Don't Have Any Money Saved Up for Emergencies
While it may feel good to pay off your car loan and get it completely out of the way, it might not be a great move if you won’t have sufficient savings or emergency funds after doing so.
It’s best to have money tucked away in case you have any car repair emergencies or if there’s anything important that you need to attend to. If you aren’t prepared for emergencies, it might be better to prioritize building your emergency fund up rather than paying your car off.
You're Almost Done Paying Off Your Loan
If there are only a small number of payments left to make on your vehicle before it’s paid off anyway, then you might just want to keep making payments on it instead of paying it off.
Chances are that you won’t save very much money on interest if there are only a few payments left to make on your auto loan. Paying your loan off early probably won’t make much of an impact on your credit score either.
Deciding Whether Paying Off Your Car Loan Early Is Right for You
If you’re thinking about paying off your car loan early, be sure that you understand the pros and cons of doing so. Paying off your car loan might negatively impact your credit score, but usually, these changes will just be temporary.
Are you in need of auto financing? Apply for a car loan now and get approved in a matter of minutes.