Should I Pay Off My Car to Buy a New One?

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The NFCC often receives readers questions asking us what they should do in their money situation. We pick some to share that others could be asking themselves and hope to help many in sharing these answers. If you have a question, please submit it on our Ask an Expert page here.

This week’s question: I have been working on improving my credit score the past two years. I currently have a car loan at 16% interest, which I have paid on time (except for two instances), and the balance on the loan is approximately $12K at this point. This vehicle will be driven by my teenager in a few months, and I need to purchase or lease a new one for myself. Would paying off my current car loan in full before I finance or lease a new car improve my chances of getting a lower interest rate on my new vehicle? Or should I continue to make monthly payments?

It shows that you’ve been working on rebuilding your credit score when you are carefully planning your next big purchase. Paying off a car is one of those financial decisions that may be right in some cases but not in others. It all depends on your current credit history and overall financial situation. However, in your case, it may be convenient to pay off the car early if you have the money to do so.
Financing Two Vehicles Can Be Difficult
Although it’s possible to finance two vehicles simultaneously, it can be challenging to meet the lender’s criteria if you don’t have stellar credit and enough income to afford both cars. Without too many details about your current financial situation, you have to determine on your own if it’s even an option for you to inquire about financing a second vehicle at this point. But, if you pay off your car, you don’t have to worry about that since you will increase your buying power and show lenders that you have more disposable income to pay for the new car.
Car Loans, Interest Rates and Credit Scores
Like many of us dealing with this pandemic, car dealers have adapted. Nationally, the average interest rate for new cars is around 7%, and some car dealers are even offering 0% financing to qualified buyers. So, if you have been working to rebuild your score and have a good score (670 to 739) or better, you should be able to qualify for a loan with a decent interest rate.
Paying off a car loan early does not offer a significant increase in a credit score. If anything, for consumers who have lower scores, relatively new credit histories, or don’t have a variety of credit accounts, it may have the opposite effect. The main benefit a car loan brings to consumers’ credit is to build a positive credit history with their timely monthly payments. If the loan is paid off, the account will remain on the consumers’ report for seven years, but its positive impact on the score will be less.
Pros and Cons of Paying Your Car Loan Early
If you pay off your car early, you may be improving your ability to qualify for a new car loan at a possibly much lower rate than the 16% interest you currently have. Paying off this high-interest loan can help you increase your cash flow to pay for your new car and to offset the cost of adding your teenage daughter to your insurance policy. Also, since you will own your car, you can adjust your insurance policy to meet your needs.
A downside of paying your car early is paying fees (if your lender has a prepayment penalty) and not making the most of your money. If you have other high-interest debt, it can make more sense to use some of that money to pay it off to maximize your savings on interest. Also, you may need those funds to start an emergency fund if you don’t have one. It all depends on your unique situation.
You are in a particular situation with a well-defined goal in mind. It looks like paying off your car could help your chances of financing a new car more comfortably. When you are ready, compare rates between lenders and look for a loan that’s right for you and your budget. Good luck!