Congrats on your windfall of cash! You know you're an adult when you consider paying off your car loan rather than blowing it on fun but frivolous things. You may want to think twice before paying off your loan, especially when you consider its potential impact on your credit scores. Here are the pros and cons of paying off your auto loan ahead of schedule.
Check the Fine Print of Your Auto Loan
Be sure to check your loan details before making any additional payments beyond the required monthly payment. Even if you decide to only pay down a larger chunk on your loan, you want to make sure that you're paying down the principal, which is the amount borrowed, and not simply making payments in advance. Bottom line: Get on the phone and talk with your lender.
After talking with your lender, you should know the pros and cons of paying off your loan early.
- Give yourself freedom: Anytime you pay down debt, it gives you the chance to afford more freedom to do ... well, whatever you want ... without having to go into debt. So, if you get rid of those car payments and the interest charges that come with them, you'll be able to put that money away and save up for your next car, which you'll hopefully be able to buy without taking out a loan.
- Reduce your car insurance cost: Lenders require full insurance coverage. Take a closer look at your comprehensive and collision coverage and see where, or if, you can make adjustments.
- Don't expect a big credit score boost: Wait, what? Many people understand that paying off their credit cards is a great way to boost credit scores, and they are right. But auto loans are different. While credit cards are revolving loans (meaning you charge them up and pay them off again and again), auto loans are installment loans (meaning you get a fixed amount and when you pay it off, it's done). So, when you pay off an auto loan early, you're effectively losing the opportunity to show the credit bureaus that you're good at paying your bills on time. Well-managed loans with timely payments show that you're effectively managing credit right now rather than just in the past. This all rolls up into your FICO score, so paying off that loan early won't necessarily hurt your credit score, but it's not likely to help it either.
- It may not be as easy as you think: Some lenders' contracts don't allow you to simply pay down the loan prior to the contract's end. Lenders lose money when a loan is paid off ahead of schedule. Don't be surprised if to pay off the loan early, you have to add an additional month's worth of payment or let them name your first-born child (kidding). Check to see if you have the option to refinance the loan and then pay it down.
- Other investment options can offer better returns: Today's auto loan rates are relatively low (you can compare auto loan rates and find one that you're likely to qualify for over at Experian.com. If you're locked into a good one, it may be worth looking at other investment opportunities with your newfound money. Give your financial adviser a call and see what's up. Or if you have credit card debt with higher interest rates, you may want to put your money into paying that down.
While limiting your debt-to-income ratio is always a good thing, it's important to understand the details and nuisances of your personal car loan before you decide to pay it off. Uncover some of the details above and develop a strategy that makes your money work harder for you. Oh, and congrats on the cash!