Paying Off Your Car Loan Early: Pros, Cons, and Expert Tips

With car loans on the rise, especially as electric vehicles gain traction, many people are thinking about ways to reduce their debt sooner. According to a recent report from The Straits Times, car loans—including for EVs—have increased significantly, but borrowers appear financially stable, managing their monthly payments without trouble.

The appeal of becoming debt-free is strong, but early repayment can bring surprises, like potential prepayment penalties or effects on your credit score. Some lenders may have specific rules on lump sum payments, making it crucial to know your contract terms. Additionally, an early loan payoff can have unexpected effects on your credit score. It’s essential to weigh these factors to make an informed decision.

In this article, you’ll uncover the pros and cons of paying off a car loan early, how it might influence your credit score, and practical tips to avoid potential pitfalls.

Is Paying Off a Car Loan Early Worth It?

If you would like to know whether you were able to save money by paying a car loan earlier than its set tenure, then you would find out that there is a slight difference: you would still actually pay more if you stuck with the loan tenure, in this case, a seven-year loan.

But car loan applicants would have to remember that banks still charge early settlement penalties on top of the total redemption amount. Usually this is at one percent to 1.5 percent of the total financed amount.

For the Toyota Vios, you would pay $71,078 if you follow the seven-year loan tenure, but complete repayments four years into the loan would require a total loan redemption amount of $29,627.27.

This means you would have spent a total of $70,343.67 including the early settlement penalty if you pay this seven-year loan three years earlier — a difference of $1,726.83.

This is quite a small change considering that you practically shaved off three years from the loan tenure. But the worthiness of early settlement depends from one customer to another: there are those who value financial security and thus would consider paying off loans earlier, while some may look to invest available money for it to grow over time.

Pros and Cons of Paying Off a Car Loan Early

Paying off an auto loan early can bring both financial benefits and potential drawbacks. While the idea of eliminating debt sounds appealing, it’s essential to weigh the advantages and disadvantages carefully. Here, we’ll explore the key pros and cons to help you decide if early repayment is right for you.

Pros of Paying Off a Car Loan Early

• Interest Savings: In the example used, paying a car loan four years into a seven-year contract would enable you to save $1,726.83 — a small part considering the years removed from the loan, but at the same time a generous amount that can be used for other purposes.
• Debt Freedom: Eliminating a recurring car payment brings a sense of financial freedom. Not having this monthly obligation can relieve stress and provide a strong sense of accomplishment. Debt freedom can also enhance your overall financial confidence, allowing you to focus on other goals without the burden of a loan payment.
• Increased Monthly Cash Flow: When you no longer have a car payment, you free up funds that can be used for other financial priorities. Whether it’s saving for a vacation, investing, or covering unexpected expenses, having more monthly cash flow adds flexibility to your budget.
• Improved Financial Health: Reducing debt can improve your debt-to-income ratio, a factor that lenders look at when evaluating creditworthiness. By paying off your car loan, you strengthen your financial profile, which may help when applying for future credit or loans.

Cons of Paying Off a Car Loan Early

• Prepayment Penalties: Some lenders charge a prepayment penalty for paying off a loan early, which can offset some of the financial benefits. Check your loan agreement or speak with your lender to see if this applies. Knowing about potential fees upfront can help you avoid unexpected costs.
• Credit Score Impact: Paying off your car loan early can affect your credit score, as closing an installment loan reduces your credit mix. According to credit experts from Bankrate, this might lead to a temporary dip in your score. If you’re planning to apply for a major loan soon, consider this potential impact on your credit profile.
• Loss of Liquid Cash: Using your savings to pay off a car loan might reduce your cash reserves, which could be problematic if unexpected expenses arise. Maintaining a balance between paying down debt and preserving cash for emergencies is essential, especially if your finances are tight.

Understanding Prepayment Penalties

Prepayment penalties are fees that some lenders charge if you pay off your car loan before the end of the term. These penalties are meant to offset the interest income lost by lenders when a loan is paid off early.

For example, an early redemption of a DBS Car Loan incurs a penalty of 1% of the original loan amount. This early payoff penalty can add unexpected costs, so it’s important to understand your loan terms.

How to Check if Your Loan Has a Prepayment Penalty:

• Review Your Loan Agreement: Look for clauses mentioning prepayment or early payoff.
• Contact Your Lender: Ask directly if any fees apply for early loan payment.
• Check for Specific Percentages: Many lenders charge a fee based on a percentage of the original loan amount, like DBS’s 1% fee.

Banks vs. Moneylenders: Different Penalty Approaches

Not all lenders have the same prepayment penalty policies. Traditional banks often have stricter penalties to deter early loan payoff since they rely heavily on interest income.

In contrast, some moneylenders might be more flexible. They may even offer discounts or reduced interest rates for borrowers who are willing to settle their loans early. This flexibility is often used as an incentive to encourage early repayments, making it worthwhile to negotiate.

Does Paying Off a Car Loan Early Affect Your Credit Score?

Paying off a car loan early can lead to a temporary dip in your credit score. This happens because closing an installment loan reduces your active credit lines, which may slightly lower your score. However, the credit impact of paying car loan early varies depending on other factors in your credit profile.

Factors Influencing Credit Impact:

• Credit Age: Removing an older account can lower your average credit age, which is a key factor in your score. Older accounts demonstrate credit stability, so closing one prematurely may cause a minor decrease.
• Credit Mix: A diverse credit mix—installment loans, revolving credit, etc.—boosts your score. If you lack other types of credit, closing a car loan could impact your credit mix negatively.
• Closed Accounts: Experian notes that when you fully repay an installment loan, it’s marked as a closed account on your credit report. Closed accounts tend to have less impact on your credit score compared to open, active accounts.
• Debt-to-Income Ratio: Reducing debt by paying off your car loan improves your debt-to-income ratio, a critical factor lenders consider. This reduction can positively influence your overall financial profile, offsetting some credit impacts.

Tips for Mitigating Credit Score Impact:

• Consider Timing Your Payoff Wisely: If you’re planning to take on a major loan, like a mortgage, in the near future, hold off on paying off your car loan until after you’ve secured new credit. This way, any temporary dip in your score won’t impact an important loan application.
• Keep Other Credit Lines Open: Maintaining other open accounts can help balance the effect of closing your car loan.
• Use Revolving Credit Responsibly: Managing a credit card or other revolving credit can show consistent credit behavior, helping to offset any score decrease.
• Maintain Low Balances on Credit Cards: If you’re using credit cards, aim to keep balances low, ideally below 30% of your total credit limit. High utilization can negatively impact your score, so keeping low balances or paying off balances regularly will demonstrate responsible credit behavior.
• Monitor Your Credit Score Regularly: Sign up for credit monitoring to track changes after paying off your car loan. Monitoring helps you understand how your actions affect your score and allows you to catch any unexpected changes early. Some credit card companies offer free credit score tracking as a perk.

Interest Savings vs. Investment Potential

Deciding whether to pay off a car loan early often involves evaluating interest savings versus the potential benefits of investing that money. For example, let’s say you have a remaining loan balance of S$10,000 on a DBS car loan at a 2.78% interest rate with two years left. Paying it off early could save you around S$278 in interest over the remaining period. This amount depends on your specific loan terms, so it’s essential to confirm exact figures with your lender.

However, investing that same S$10,000 could yield higher returns, especially in a retirement account or investment fund with an average 5-7% annual return. With a 6% return, you might earn S$600 in one year, which is more than the interest savings from an early loan payoff. This “opportunity cost” should be considered, particularly if market returns outpace your loan interest rate.

Factors to Consider

• Interest Rates: If your car loan has a relatively high effective interest rate (e.g., above 5%), paying it off early may offer more savings than investing, especially for high-cost loans like those for used cars with rates around 6.68%, such as Hong Leong Used Car Loan.
• Tax Considerations: Auto loans typically don’t have tax benefits in Singapore. However, if you hold other tax-deductible debt (like education or business loans), prioritizing those debts over a car loan might offer a better financial advantage.

Balancing these factors can help you make an informed choice that aligns with your financial goals and maximizes your overall savings.

Practical Steps to Pay Off Your Car Loan Early

If you really want to end your car loan, or maybe you want to get a new car and would have to sell your old car that still has remaining payments, the best way is to accumulate funds first before deciding on early redemption.

Review Loan Terms

Begin by reviewing your loan agreement to check for any prepayment penalties or restrictions. Some lenders, like OCBC and Maybank, may charge a small fee for early payoff, so it’s crucial to understand the costs involved before proceeding.

Budgeting for Early Payoff

Next, incorporate extra loan payments into your monthly budget. Set aside a dedicated amount each month toward your car loan payoff by cutting back on non-essential expenses. Even small adjustments, like reducing dining out or entertainment spending, can help build extra funds to apply toward your loan balance.

Additional Payment Options

• Make Bi-Weekly Payments: Instead of making one monthly payment, pay half of your loan amount every two weeks. With 26 bi-weekly payments in a year, you’ll end up making an extra full payment annually, which can reduce the overall loan term and interest.
• Round-Up Payments: Round up your monthly payments to the nearest $10, $50, or $100. For example, if your payment is $340, rounding it up to $400 can add up to significant savings over time and shorten the loan term without a big impact on your budget.
• Lump Sum Payment: One thing you can do is to set aside all extra income and bonuses that are excesses to what you need monthly. From this, you can actually save money to pay the early redemption costs. This approach reduces the loan’s overall balance, resulting in less interest paid over time.
• Increase Payment Frequency: Opt for weekly payments instead of monthly ones if your lender allows it. This higher payment frequency can accelerate loan reduction and reduce interest charges, allowing you to pay off the loan faster.
• Look for other jobs. Set up a business, or basically increase your income. You can also look for part-time jobs which would help you complete the loan.
• Use another loan to cover another loan. Like a debt consolidation program. Loan finders in Singapore like Instant Loan offer loans that would give you the money needed for the early redemption of your car loan.

When Refinancing May Be a Better Option

Refinancing a car loan involves replacing your current loan with a new one, typically at a lower interest rate or longer term, to reduce monthly payments. Unlike an early payoff, which clears the debt, refinancing allows you to restructure it for more manageable payments.

Pros of Refinancing Over Early Payoff

• Lower Monthly Payments: Refinancing at a lower interest rate can significantly reduce your monthly car payment, easing financial pressure.
• Maintain Cash Flow: By lowering payments, refinancing helps you keep more cash on hand for other needs, such as savings or unexpected expenses.

Situations Where Refinancing Is Ideal

Refinancing is a smart choice if you have a high-interest debt loan or if paying off the loan early would drain your savings. It’s also ideal if your credit score has improved since you took out the original loan, as this can help you secure better terms. For borrowers looking to lower monthly obligations without a full payoff, refinancing offers flexibility without compromising cash flow.

Real-Life Case Studies

Example 1: Early Payoff Success

John, a Singaporean with a DBS car loan at 2.78% interest, decided to pay off his remaining balance two years early. By doing so, he saved about S$400 in interest. While his credit score dipped slightly after the loan closure, his debt-to-income ratio improved, boosting his eligibility for a future mortgage. With no car payment, he enjoyed increased cash flow, allowing him to save more monthly and plan a family vacation.

Example 2: Choosing Not to Pay Off Early

Emma had a UOB car loan with a similar interest rate but opted not to pay it off early, prioritizing her cash flow for investments. Her money earned an average 5% return, exceeding her loan’s interest rate. Maintaining the loan helped her build a credit history, keeping her score stable. Financially, this approach allowed her to grow her investment portfolio while managing her monthly payments comfortably.

Example 3: Refinancing for Flexibility

James, with an OCBC car loan at 5.19%, chose refinancing over early payoff. By refinancing to a lower rate, he reduced his monthly payment, easing his cash flow without fully depleting his savings. This middle-ground approach allowed him to maintain financial flexibility while lowering interest costs, helping him manage other priorities, like unexpected expenses and future investments.

Conclusion

Paying off your car loan early offers valuable benefits, but it’s essential to consider all factors, including potential penalties and credit impacts. By weighing the pros and cons, assessing your financial priorities, and exploring alternatives like refinancing, you can make the best decision for your unique situation.

Key Takeways:

• Paying off a car loan early can save interest, but consider if investing those funds might yield higher returns.
• Early payoff may temporarily lower your credit score and could incur prepayment penalties, depending on your lender.
• Refinancing can lower monthly payments and maintain cash flow, offering a flexible option if early payoff isn’t ideal.

Take control of your finances and make smarter choices for your car loan! Whether you’re planning to pay off your car loan early, refinance for better terms, or explore flexible loan options, Instant Loan has you covered. Request free loan quotes today—no obligation to apply required!