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Knowing When to Pay Off Your Auto Loan

car and keys on top of money
No one wants to have car loan debt. Cars lose value the moment you drive them off the dealer’s lot, causing some people to eventually owe more than what their cars are worth.

Whether people want to or not, they have to repay the auto loans they borrowed. However, paying off your car loan sooner rather than later might be unwise.

In order to avoid any potential fees and lost opportunity costs, it is important to determine when borrowers should and shouldn’t pay off their auto loans. Timing can be everything in life, and when it comes to borrowing car loans, it can make the difference between saving or losing thousands of dollars.  

To find out more about knowing when to pay off an auto loan and how its timing would affect borrowers, loans.org interviewed a whole group of finance experts and advisors.

Look Before You Leap

Harrine Freeman, CEO of H.E. Freeman Enterprises, told loans.org that before even thinking about paying down an auto loan, borrowers should look at the interest rates on their other debts.

“If you have credit card debt that has an interest rate of 11 percent, a mortgage loan that has an interest rate of 6 percent, a student loan with an interest rate of 6.8 percent, and a 3.9 percent interest rate for your car loan, you should focus on paying off your credit card debt since it has the highest rate (11 percent),” she said.

Freeman advises borrowers to make regular payments on their bills, and once they have paid off any sizable credit card debt, they can focus on paying off their car loan. She noted that consumers can get tax credits for student loan debt and for being homeowners — yet there is no tax credit for owning a car, let alone for borrowing money to buy a car.

Only when a car loan has an interest rate that is higher than all other debt does Freeman recommend prioritizing paying it off. She said that if a consumer’s car loan has a 10 percent interest rate while all their other debts (such as credit card, student, and mortgage) have lower interest rates, then paying off the car loan first makes logical financial sense.  

Should a borrower have a car loan with a low interest rate, Freeman recommends paying it off only if it is 4 percent or lower.

“My interest rate on my car loan is 2.9 percent, the interest rate on my mortgage is 4.375 percent and the interest rate on my credit card is 11 percent. So if I have a credit card balance I would focus on sending extra towards my credit card debt and continue to make regular payments on my car loan and mortgage loan until my credit card debt is paid off,” she said.

Saved By Savings

Peter Murray, Co-Founder at HowellCorp, urges caution before throwing money at paying down car loans. His financial services company advises its clients to first establish an emergency savings that covers nine months’ worth of regular expenses. He pointed out that emergency savings allow people to respond to life’s unexpected challenges — such as layoffs — while avoiding taking on high interest emergency debt.

Murray agreed with Freeman that high interest debt should be prioritized first, but only after a cash reserve has been built up. He also said that people may want to pay off their cars first in order to simplify the private sale of the vehicle. Paying off the car would allow the owner to eliminate the lender from the process and would make a “cash for pink slip” transaction possible. 

A Wary Rule and Early Payment

Cliff Balson, Former General Manager at JD Byrider, told loans.org that car loans should be paid off sooner rather than later since they amortize according to the rule of 78s. He said that borrowers will ideally have a car loan that has no prepayment penalties and that stipulates any surplus payments are to be applied directly to the principle.

“Since automobiles are not assets that appreciate in value, it is sound financial sense to pay off the vehicle as quickly as you can,” said Balson.

According to Bruce Specter, Advisory Mortgage Planner at Movement Mortgage, paying off a car loan early may make sense if the consumer has an equity event that allows them to comfortably make that payoff without affecting their quality of life. If a borrower’s auto loan has less than a year left in its lifetime, then Specter advises to just wait it out. He cautions auto loan borrowers to always view their entire financial situation before deciding to pay off any one debt.

Unfortunately for many borrowers today, their financial situation almost always includes one burgeoning debt category.

Student Debt Threat

Specter feels that the ballooning student debt crisis may end up forcing borrowers to prioritize student loan debt over auto loan debt.

“With the much-publicized increase (doubling) in student loan interest rates today, this potential next bubble will continue to be front and center,” said Specter. “Student loan repayment is a major concern for current students and graduates alike. Again, depending on the terms of the loan, that monthly amount needs to be figured into the personal budget. As the rates on these loans move higher, retiring them sooner is the smarter play.” 

Fortunately for borrowers juggling multiple types of debt, there are two prominent debt payment strategies that can be applied to not just student loan debt but also car loan debt.

Wintery Weapons against Debt

Anton Ivanov, Founder of Fortnoff Financial, believes that using the “snowball” or “avalanche” approaches to debt is better than just looking at any one type of debt, even auto loans.

Under the snowball approach, the debt with the smallest balance is paid off first. Under the avalanche method, the debt with the highest interest rate is paid off first. Borrowers build confidence by using the snowball approach, and they save money on interest when they use the avalanche approach.

“The interest rate and balance of a car loan will determine its priority during the process of repaying multiple debts,” he said. “If the car loan has the highest interest rate among an individual's loans or credit cards, it should be focused on first. If the car loan has an especially small balance compared to other debt, it can also be prioritized. The bottom line is that an individual should strive to pay off his or her debts as fast as possible.”

Eyes on the Score

Johnathan Ness, CPA, told loans.org that borrowers should only pay off their car loans early if their credit score is already built up.

“If you have no credit history or low credit and want to buy a house or refinance, take your time with your car payments to build your credit score,” said Ness. “The money you save in lower mortgage interest will be very well worth what you pay in car payment interest.”

Ness said another reason to pay off your car early is if borrowers are shopping for a house in the near future and need to get their loan-to-income ratio in line with their bank's requirements. Most banks want both mortgage and total debt payments to be less than certain percentages of borrowers’ incomes. Paying off credit card loans, student loans, and car loans can make it easier for them to qualify for a mortgage.

According to Ness, the typical borrower’s situation usually requires credit cards be paid first, followed by car loans, and then finally student loans. He said that as far as consumers should be concerned, it looks better on their credit score if they have a car payment rather than equal amounts of credit card debt since the latter is seen as far riskier due to lacking collateral.

Ness pointed out that it is very rare for a borrower to be in a situation where they would want to pay off their mortgage loan prior to their car loan. Reason being, borrowers are more likely to have higher interest rates on their mortgages. If the interest rate on a mortgage is sufficiently high, then it may make more sense to pay a car loan off later.

By using the advice these experts have detailed, borrowers can be in better positions to determine when the right time to pay off an auto loan is versus when they should be prioritizing other debt. Perhaps more importantly, borrowers should recognize that the relief they gain from paying off a car early is nowhere near the safety and satisfaction brought about by a healthy cash reserve that hopefully never needs to be used in event of an emergency.

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