Don’t Rush to Pay Off Your Car Loan
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UPDATED: Nov 19, 2012
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No one wants to be in debt, especially in the form of car loans. This type of debt is widely viewed as a form of “bad debt” for a number of reasons. Compared to say student loans—which gives you an education—or a mortgage—which gives you a home—a car loan simply gives you a vehicle that is losing value month-by-month, year-by-year. Unfortunately for many borrowers, vehicles are unlikely to rise in value as the years go on due to the wear and tear of driving, maintenance costs, and the inevitable passing of style.
For these reasons, it seems like common sense that one would want to pay their auto financing off early. But that may not always be in the best interest of borrowers. The majority of questions about car loans ask about how to apply and obtain financing, not what happens after the balance is paid off. However, there can be a downside to paying off a car loan, so borrowers should stop and weigh the pros and cons before rushing to pay off their balance.
Vehicle financing is lent with the purpose of turning a profit. Lenders make money off the interest that accrues on each of their lent loans. Consequently, the longer somebody has a loan, the more money they will pay a lender in interest. Having to pay interest and monthly payments for years on end is not a prospect many would welcome.
In order to avoid paying that interest, willing and able individuals often try to pay their loans off early.
While car payments can be a burden to borrowers’ budgets, they also leave out alternative uses for money. Instead of making sizable monthly payments on a car loan, borrowers could instead use that money for saving towards the purchase of a home. Similarly, borrowers could save money to start a business or pay off other debt like student loans or credit cards. Once borrowers pay off their car loans, these beneficial options open up—in essence a path to greater rewards and living.
These beneficial options, such as now being able to save money that would have otherwise gone to a monthly vehicle payment, are the result of an opportunity cost.
An opportunity cost is the benefit (or lack of benefit) that results from a decision. For example, a borrower using money to pay off a balance has foregone the ability to use that money for something else, such as the purchase of a car. That’s the opportunity cost: being unable to purchase something else with that money.
Outside of financing, opportunity costs manifest in a number of other scenarios. The fact is, most everyone experiences opportunity cost scenarios whether they know it or not. For example, a boy who has saved his money over the course of a summer decides he wants one of two toys. He either wants to purchase a bike or a video game console. Unfortunately, he only has enough money for one toy. If he purchases the bike he will be unable to purchase the video game console. Similarly, if he purchases the video game console he will not have the money to purchase the bike. Purchasing one toy literally “costs him the opportunity” of owning the other toy.
Similar to opportunity costs there are downsides to paying off car loans.
While paying off car loan debt is a good thing, there can be a shocking downside to doing so as the following example illustrates.
A person who still owes $12,000 on a car is proud to finally save enough money to pay it off. The borrower pays off the $12,000 and then a few months later applies for a small business loan. The borrower is rejected and finds out via a credit report that his credit score has actually dropped!
Shocked, the borrower investigates and finds that his credit score fell since, now that the car loan is paid off, the only remaining debt on record for the borrower is a credit card.
You see, paying off that car ended up changing the borrower’s balance-to-credit limit ratio. Money still owed is considered more valuable in credit score calculations than an owed amount that was paid off. This is because in lenders’ eyes, a person who owes money and makes steady payments is prized as a good borrower. A higher credit score is their reward. In contrast to this, paying off car loan debt removes that factor from credit score calculations. A borrower’s credit history will still show that a loan was successfully paid off, which is a positive thing even in lender’s eyes, but it will not result in a credit score increase. For these reasons, paying off financing can result in a credit score drop. This drop could make it difficult to borrow money for another purchase.
Additionally, certain lenders stipulate that borrowers will have to pay a fee if their debt is repaid early. This fee could prove costly to some borrowers since it is bad enough they have already saved money to pay off money that is owed. Borrowers can avoid this fee by not paying off their car loan early and instead making regular monthly payments. However, borrowers will wind up paying a greater sum of money in interest payments, rather than paying their debt off early.
Ultimately, borrowers have to decide if they want to pay off their balance at the risk of damaging their credit score or keeping their debt and making steady payments for the lifetime of their car loan. This is an important decision that is highly dependent on the specific financial situation of each borrower. It is not a decision to be made lightly or hastily without some serious financial planning.