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For a lot of reasons, it could make sense to pay off your car. To many folks, it may even seem obvious, but is it really? In this article we will try to pinpoint the exact reasons, and thus benefits, it may be a good idea to pay off that car note. If you are interested in reasons that you may NOT want to pay off your car loan we have an article just for you here, ‘Reasons Not to Pay Off Your Car Loan.‘ There are a lot of factors to keep in mind when making such a big decision.
Reason #1: Lower Car Insurance Premiums
The first reason you might want to consider if you are thinking about paying off your vehicle is the impact it could have on your car insurance premiums. Typically, a Full Coverage Policy is required on a vehicle when it is backed by a bank loan. This insurance covers the vehicle even if you are at fault. Unfortunately, this type of insurance can be exceptionally expensive depending on the laws and driver behaviors of your local area.
By paying off your car you are no longer required to keep a Full Coverage Policy. A Liability Policy is one where you are only insuring damage to other vehicles in an accident. Any damage to your vehicle that you are liable for according to your state laws will not be covered. Now, is it a good idea to be driving day in and day out in an expensive vehicle with a terrible accident history with only liability coverage? Probably not. But that doesn’t mean it may not make sense for some folks.
If you can self-insure your vehicle… in other words, you have a large enough cash cushion that you could easily replace your vehicle if you end up in an accident that does damage to your own property that you are liable for, then having liability insurance may be the way to go. If getting into an accident and potentially losing your car without any type of restitution will cause you significant financial or emotional distress, then by all means you should continue paying for your Full Coverage Policy.
Reason #2: Lower Monthly Budget Requirements
Many folks, particularly those on a fixed income, try and manage their income and expenses on a monthly frequency. By removing a monthly payment, it may free up cash flow that is needed elsewhere. Obviously, this doesn’t come without a catch: a lump sum will have to come from somewhere to make the payoff. It may be possible that the lump could be used better elsewhere (perhaps, in investments or a savings account?). But, if a better use of the money cannot be found, then paying off your vehicle to lower your monthly outflows may make sense.
Reason #3: Preparing for a Large Purchase Such as a Home
A fantastic reason to shore up your monthly obligations is when you are getting ready to purchase a home. When applying for a mortgage, banks look at your overall expenses on a monthly level to determine if you qualify for a loan. They look at things like credit card balances, car loans, childcare expenses among other things to underwrite your risk. By paying off a car loan you are lowering the amount of money you have going out the door and thus freeing up the percentage of your income available to pay a mortgage on a monthly basis.
There is a rule of thumb when it comes to how much mortgage you can afford. The 28%/36% rule suggests that you should be spending no more than 28% of your gross monthly income (before taxes) on your home and no more than 36% on all debts combined. By paying off your vehicle you will be lowering the amount that you are spending on that 36%. If your car loan is too high, it may impact your ability to get a mortgage at some point. Ensuring it doesn’t come to that may mean paying off your car note or putting down a larger down payment.
Remember, the above percentages are just a ‘rule of thumb’. I, personally, could not possibly imagine spending 28% of my income on a home… or 36% on debt for that matter. But, the numbers are a good illustration of the tradeoff that comes with paying off various forms of debt when considering buying a house.
Reason #4: Your Interest Rate is too High
Paying too much in interest each month is a solid reason to pay off your car. Depending on your interest rate, you could be paying more money on interest than on the actual vehicle. Even if your rate is much lower, someone is profiting off your car payment each month. You may want to ask yourself if it is worth it to you to be paying this fee if you can stop it. Alternatively, if your loan has a 0% interest rate (or any rate below inflation) then this reason won’t be a good one to pay off your loan. Look at your account statement and see how much you are paying in interest. Put it on a sticky note and stick it to the refrigerator. It’s a great reminder of the hidden cost of keeping debt.
Reason #5: Lower Stress and Simplify Lifestyle
This reason may apply to more people than you might think. With interest rates low and post-pandemic stimulus flooding the markets, many folks may not have a good reason to pay off their cars based on the other reasons in this article. They may not come out financially ahead (perhaps they have a 0% interest loan) or perhaps they don’t necessarily want to change their insurance coverage. Perhaps, however, they just want to stop thinking or worrying about the payment.
This is not a bad or cheap reason. Alleviating the mental burden that comes with owing money is a great reason to pay off your vehicle. Not having to worry about getting the payment in on time or any other detail is worth it if it has even a smidge of an effect on your mood when thinking about your budget. Simplifying your finances is never a bad thing.
Reason #6: You Ultimately Want to Sell or Donate the Vehicle
If you have enough time prior to wanting to sell or donate your vehicle, then paying it off first may make sense. When you pay off your vehicle, you will be eventually given your Title by your loan company. With Title in hand, you will now be free to donate or sell your vehicle easily. Generally, a Title allows the ownership of a vehicle to change with the little effort more than a pen stroke. Having an outstanding loan on a vehicle during a sale (not to a dealership) or when you wish to donate it will complicate the process… possibly even making it impossible in some cases. Thus, pay off your car… get your title… then sell or donate it.
Conclusion and Financial Warning
These are all reasons to consider paying off your car. For reasons to consider not paying off your vehicle then please check out my article entitled ‘Reasons Not to Pay Off Your Car Loan.‘ Please remember that I write this blog as an individual looking to share to my own thoughts and opinions. For your own financial situation, you should look for advice tailored towards your individual financial reality. I would recommend talking to your Certified Financial Planner or Accountant… neither of which I am.