Is It Always Good to Pay Off Your Car Loan Early?

By 8 Comments

Is it always good to pay off your car loan early, right? There are the obvious benefits:

  • more money in your monthly budget,
  • improvements to your credit (increased ability to borrow),
  • lower insurance opportunities, and
  • the general good feelings from not having a loan.

One other area that’s often touted as a benefit is that you are escaping the interest charges on the loan. The general advice is to look at your interest rate, for example 7.5%, and say, “your money could be doing more for you each month if it weren’t tied up in those loan costs of 7.5%.”

But what if you are in your final years of a 5 or 6 year loan? Does the fact that you aren’t paying near as much interest each month in actual cash outlay now make a difference in your decision? Let’s look at this example. Back in July of 2006 you borrowed $15,000 at 7.5% for 5 years to pay for a car. Here are the first and last year amortization schedules:

Car Loan Amortization Schedule - Year 1

Year 1 of the car loan.

In the first year of this car loan, you pay over a third of the financing costs.

Car Loan Amortization Schedule - Year 5

Year 5 of the car loan.

In the final year, you only pay just $163 to finance this car. So even though you are still paying annual interest of 7.5%, the actual cash outlay is nowhere near what it was in the first two or three years.

Does it make sense then to pay the car off early (at 48 months for example), just to save $163? Am I reading the numbers right? Should this be a factor?

From my experience, paying off a note early had more to do with my cash situation over anything else. If I have enough cash, I don’t want to have debt, regardless of the interest rate. I want the payment out of my life, and I want complete control of the asset. If I’m short on cash or trying to build cash reserves, I’ll hold on to some reasonable debt (i.e. 7.5% car loan).

What about you? Would you hold on to debt, like the car loan in the example above, even if you had the cash?




Last Edited: February 22, 2011 @ 12:31 pm
About Philip Taylor

Philip Taylor, aka "PT", is a husband and father of two. He created PT Money back in 2007 to share his thoughts on money and to meet others passionate about managing their finances. All the content on this blog is original, and created or edited by PT. Read more about Philip Taylor, and be sure to connect with him on Twitter, Facebook, or view the Philip Taylor+ Google profile.

9 comments
  Livefyre
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L
L

I'm facing this question right now. I owe $1965 on my car, I have an interest rate of 8%, my monthly note is $303, and it's due to be paid off in July. I've been paying $400 for the past several months.

I can comfortably pay off the amount due, to start the new year off debt free. Or I could pay half next payment and half the month after. Or continue paying $400 and I will start my personal new year debt free.

Decisions, decisions... *sigh*

However I do it, when it's paid for I plan to funnel that money into my retirement funding and a little bit each month to my dad who's on a fixed income.

Alejandro
Alejandro

It all depends on what you are going to do with the money you already have. Let's say for example you owe $10K to the bank and you suddenly receive a $10K bonus at work. If I have a stable job, I would not pay the debt off (nor buy something I don't really need), I rather invest this money in something that can give me some earnings.
This is what companies do; even though they have some large revenues, they don't use this money to pay off their debts, they reinvest the money and with the earnings they amortize the debt and pay interests.

Jackie
Jackie

I would definitely not hold on to a car loan in the situation you describe. About the only advantage I could see to owing money at all would be if it somehow reduced your monthly expenses to a ridiculously low level -- like by stretching out a home loan so you only paid a couple hundred per month -- but even then my gut would want to pay it off.

PT
PT

@biddy - Interest should accrue the exact same way in Canada, yes. The best % to put down is always 100%. :) But if that's not doable, then shoot to find really low financing through a credit union and put down as much as you can. This is, of course, dependent on the fact that you have no other debt (which I know is true), and you have plenty of savings stashed away.

biddy
biddy

Hi PT,

Does the same principle apply in Canada? I will need a new(er) car one of these days.
My Subaru is 21 years young and still not too bad :-) What % is best to put down?

Biddy

Evan
Evan

What an applicable post! I am in hyper payback mode on my auto note.

I am constantly updating my auto loan amortization spreadsheet and paying it early actually collapses the back-end providing two benefits.

1) I get my $300/month back quicker and
2) I start to eliminate interest payments that would have otherwise have had to be made...so even if I am saving interest it is probably more than I would receive (at least on an auto loan) than if that money is in the bank

PT
PT

Great comments, you guys. One thing I forgot to stress in my post is that people often don't realize that interest is paid this way. When you break out the amortization schedule, it really forces you to see the costs of those first few years.

The Happy Rock
The Happy Rock

PT,

I think the question is what value does paying it off provide and what would you be giving up to do or not do it.

Couple of things come to mind:

The emotional side of things is significant. The amount of motivation and energy that can be gained by totally scratching off a debt is pretty high. The singular focus on the next debt or task is a great tactic.

The cash flow of $300 a month that you gain if you pay it off early is significant.

Finally, what would you be doing with the money otherwise, if you don't sink it into this debt? Is it going towards other debt, or in the bank, or towards spending? Is that choice more valuable than getting out of this debt, saving $160, and gaining a $300 in cash flow.

Personally, I would pay it off as fast as possible, unless it made more sense to be putting the more towards another more important debt.

Jenny
Jenny

Paying $0.00 in interest (or even gaining a little) is better than $163.00. I'd pay it off early if I could.