Can You Pay Off A Car Loan Early?

Settlement Figure: Explained

A settlement figure is what you’ll pay to fully settle your car loan before the agreed term ends.

It’s not just the remaining loan balance. In fact, it is better to consider the settlement figure as an ‘all-in’ price to settle your debt, including your loan balance as well as accrued interest and early repayment fees.

You can request this figure from your lender at any time, and they’ll calculate it based on the specific terms of your loan agreement.

Case Study: Financed Ford Fiesta

Let’s say you financed a Ford Fiesta with a four-year Hire Purchase (HP) agreement and are now two years into the loan. 

Your initial loan amount was £12,000, and after two years of monthly payments, you’ve reduced the balance to £6,000.

You decide you want to settle the loan early, so you contact your lender to request a settlement figure. Here’s how they might calculate it:

1. Outstanding Loan Balance: £6,000 (the amount you still owe on the car).
2. Accrued Interest: £300 (interest already calculated for the upcoming months).
3. Early Repayment Fee: £150 (a fee outlined in your loan agreement, often equivalent to one or two months’ interest).

Your settlement figure would then be:
£6,000 + £300 + £150 = £6,450

By paying this amount, you’d clear the loan entirely, avoid future monthly payments, and save on any additional interest over the remaining two years.

Remember – a settlement figure isn’t always the best solution. While knowledge of your specific figure is crucial to making an informed decision, only you can weigh the benefits of early repayment related to your personal circumstances.

Step-by-Step Guide to Paying Off a Car Loan Early

1. Understand Your Loan Agreement

Always start with checking your loan agreement for any early repayment fees. These fees vary between lenders, so it’s important to be aware of any potential costs.

Pay particular attention to your minimum monthly payments and any penalties for late payments.

2. Calculate a Settlement Figure

Some lenders offer online tools or calculators to estimate the settlement figure. These are lifesavers when planning your finances.

If you can’t find a calculator, you will have to reach out to your lender directly to request a settlement figure. This figure will include the outstanding balance, any accrued interest, and any applicable early repayment fees.

3. Assess the Costs and Benefits

Refer to our comprehensive benefits and downsides below to consider every aspect of repaying your loan early.

Ultimately, your decision should come down to whether the funds you’re using to pay off the loan could be better invested elsewhere.

Are you saving more by stopping interest payments, or could you accrue more money by investing the funds elsewhere?

4. Confirm the Closure

If you choose to pay off your car loan early, it’s essential to receive written confirmation from your lender. This document will serve as proof of closure that the loan has been fully settled.

Don’t forget to also update your credit report! This can help improve your credit score and future borrowing opportunities.

Benefits of Paying Off a Car Loan Early

Save Money on Interest

By paying off your car loan early, you stop accruing interest on the remaining balance. This reduced loan term translates to significant savings, especially if your loan features higher interest rates.

The interest rate offered by the Bank of England has dropped twice since August. Currently, UK drivers face a 4.75% interest rate – down from 5.25% in June.

Bear in mind – while the interest rate has experienced a 0.5% drop in the second half of the year, the rate remains high compared to the rate of 0.75% in 2019.

Improve Your Credit Score

Making consistent, on-time payments on your car loan helps build a strong credit history. 

Paying off the loan early further demonstrates your financial responsibility. Clearing a car loan can lower your debt-to-income ratio – a key metric for evaluating your creditworthiness. 

While you may experience an instant effect with early repayment, it sets you up for long-term financial health.

Gain Financial Flexibility

Once you’ve paid off your car loan, you’ll free up your monthly budget.

This flexibility allows you to focus on other financial priorities such as building an emergency fund, investing in a Lifetime ISA, or tackling higher-interest debts like credit cards. 

As the cost of living continues to rise in the UK, having extra cash flow is always great for peace of mind.

Potential Downsides to Consider

Early Repayment Charges

Many car finance agreements in the UK include early repayment fees. While it can be a bitter pill to swallow for drivers, they are designed to compensate the lender for lost interest. 

These fees are typically calculated as a percentage of the remaining balance or as the equivalent of one to two months’ interest.

While UK law under the Consumer Credit Act 1974 caps these charges for regulated agreements, they can still eat into the savings you might expect from paying off your loan early.

Opportunity Costs

Paying off your loan early ties up funds that might be better used elsewhere.

For example, if you have credit card debt with an APR of 20% or higher, paying that off first will likely save you more in interest.

Alternatively, you could invest in tax-efficient investment accounts that could amplify your returns.

Impact on Credit Score

While clearing a loan demonstrates financial responsibility, closing an account early can reduce the average length of your credit history.

Additionally, having a variety of active credit types can positively influence your score. If your car loan is one of your few active credit accounts, paying it off could reduce this diversification. 

However, this impact is generally minor and temporary – so don’t solely base your decision on this one factor.

Alternatives to Paying Off a Car Loan Early

If full repayment doesn’t work for your situation, there are other options available to you:

• Increase Monthly Payments: Paying more than the minimum each month can help reduce the loan term and interest costs.
• Make Lump-Sum Payments: Larger, occasional payments can chip away at your loan balance without triggering early repayment charges.
• Refinance Your Loan: Securing a new loan with a lower interest rate or shorter term is often more cost-effective than simply grinding through.