Paying Off Car Loans Early: Things to Know

There are things you should know if you are considering paying off a car loan early. Early payment may provide a way for you to eliminate your debts, but it is not to the advantage of the lender. The lender's income is based on the finance and interest charges built into each payment over the length of the loan period. Paying the loan off early takes away that income source, which can come at a cost to the lender, and subsequently the borrower.

Many loans will have a provision for an early payment or prepayment penalty. This penalty provides an incentive for the borrower to make scheduled payments within the prescribed period as opposed to paying off the loan too soon. The amount of penalty, which declines over time, recoups the lender's cost of money.

Financial planners have floated the idea of borrowing from your retirement plan, like an individual retirement account (IRAs) and 401(k) plan for years. The idea is that you have time to make up the reduction of your retirement asset and by paying off your debt earlier; you will save money that can be used for other purposes. The problem, aside from any penalties that may be imposed by the lender, is that you are robbing Paul to pay Peter.

In other words, a reduction in the value of your retirement assets means that you have to earn twice as much just to make up the loss earnings. Additionally, the effect of the prepayment penalty imposed by the lender will typically result in the loan costing you more than letting it run its normal term of years.

It may be a good idea to calculate the cost of prepaying a loan early versus allowing it to be paid over time. You will be able to examine the true costs of your options and make a better informed decision. A banker or financial planner that is a Certified Financial Planner or Certified Public Accountant can help you with these calculations.

An option worth exploring is setting up an account for the purpose of matching the loan amount by only paying off through a systematic monthly withdrawal. This process, known as defeasance, improves your credit standing, allows you to prepay the loan and allows the lender to receive their scheduled income based on their timetable. This avoids penalties and loss income opportunities and may be the better solution.