If you receive a windfall or earn a raise, getting rid of some debt is a smart move. Paying off your car loan may seem like a no-brainer, but has its pitfalls, making paying off credit cards or other loans a better choice.
Debt to Available Credit Ratio
Many credit score companies include your available credit-to-debt ratio when computing your credit score. By paying off your car loan, you lower your debt and usually end up raising your score. Your debt load makes up 30 percent of your FICO score (the most commonly used credit scoring system in the United States). Once your credit score improves, you'll be eligible for lower rates on other debts and accounts, saving you a lot of money over time.
Credit History Length
Creditors and credit score companies like to see a long, consistent track record of responsible credit management. Sure, you could pay off your car after six months, but that doesn't tell a lender much about your ability to keep up with a 30-year mortgage. If you plan to buy a home soon, get some guidance from a financial planner or mortgage banker: you might be better off using your extra money for a down payment on a house.
Freeing Up Extra Cash
Once you pay off your car loan, you'll have some extra cash to throw at your other debts. If you get each of your credit card balances under 30 percent of their respective credit lines, you'll give your credit score a nice big boost. Don't have credit card debts? Accelerate your mortgage, save, or invest that extra money: all three options benefit your financial health.
Early Payoff Penalties
Check your loan agreement for any early payoff penalties. In some cases, you'll end up paying a percentage of the principal as a fee when you pay off your car early, but you'll still save money in interest over time. But if your repayment penalty is “pre-computed” or “front loaded”, your early repayment will cost you the same as making payments throughout the duration of the loan term. You'll have to weigh the benefits of owning the car outright, and a possible credit score increase, against the fact that you'll be paying interest on money you no longer owe.