Making the last payment on a car loan is a great accomplishment and, for most of us, a welcome relief. But with the end of that era comes another: life as the owner of a car – “free and clear.” So what do you need to know about finances and insurance when you’ve paid off your car?
Most people finance their vehicles for five years, banker Deric Poldberg from American National Bank in Omaha, Nebraska, says. If you’ve just spent 60 months, give or take, with the same type of insurance, paperwork, and financial obligations, you might wonder what to do next.
Here, we break down the most common areas to address at the end of a financing term, including the paperwork and insurance details, and why you should think ahead and start saving for your next car loan.
Paid Off Your Car? The Paperwork & Finance Tips You Should Know
This part is easy in that you don’t actually have to do anything except verify information and signatures. In most states, your lien holder will notify the Department of Motor Vehicles (or equivalent state entity) of the title change, and once the paperwork clears, the title (with your name on it!) will be mailed to you.
Most people who just finished financing a car are used to sending in $300-$500 (give or take) per month, and once that’s over, the extra cash can feel like a windfall. You might be tempted to splurge on fun stuff or to make large purchases you’ve been putting off, but unless your transportation situation is radically changing soon, you’ll always need a car. And that means you’ll eventually need to pay for the next one.
“Once the last payment is made on a vehicle, some financial discipline can help consumers get ahead of the game with regards to their next vehicle purchase,” says Bob Harwood, vice president of InterActive Financial/Carloan.com in Richmond, Virginia. Harwood explains that people who save the equivalent of either part or all of their former monthly car payment can do their future selves a big favor when it comes to their next vehicle purchase: put extra money in savings so you can pay a larger percentage of the purchase price upfront (which usually means you’ll get a lower interest rate on your next loan and your monthly payments will be smaller).
Car Insurance: Paperwork
- Updates about Ownership: Notify your car insurance company when you’ve paid off your loan so that you can remove the lien holder from your policy. (You don’t need to wait until you have the title in your hand to make the call.) This step is important because if your financed vehicle were to be totaled in a wreck, the insurance payment would go to the lien holder, but once you’ve paid off the car and own it, the payment should go to you. You’d eventually get the money in either case, but updating the information with your insurer would streamline the process.
- Updates to Coverage: Your auto insurance rate won’t change all on its own just because you now own the car free and clear, but you can make the choice to adjust your coverage options (see below).
Car Insurance: Coverage
“Most lenders require that customers carry comprehensive and collision coverage (collectively often called “full coverage”) on their insurance policies so the vehicles are guaranteed to be repaired or replaced if damaged,” Richardson says. The reasoning is that most people don’t have enough cash to pay for the vehicle outright (which is why they are financing). Thus they are most likely not able to afford the remaining balance on their auto loan and pose a higher risk of defaulting on their loans if they don’t have that coverage.
Once you’ve paid off your loan, though, the auto insurance coverage level is up to you, as long as you meet your state’s minimum requirements. You can decline part (or all) of comprehensive and collision coverage if you decide you don’t want to have as much coverage. If you’ve just finished financing a new car, though, it’s likely to still be worth a substantial amount of money (and crashes are still, of course, a risk). A good rule of thumb, says Richardson: “If your vehicle is worth less than $4,000, you’ll likely pay more for additional coverage than the benefit you may receive at the time of a claim.”
Dropping comprehensive and collision coverage and switching to just liability coverage can significantly decrease your auto insurance payments (see page 21 of our State of Auto Insurance report for average national costs), but it’s important to weigh the potential costs of repairs against those savings.
Finally, you should reconsider your auto insurance at least every six months or year in order to make sure your vehicle is sufficiently covered and that you’re paying the best rate (with all applicable discounts) considering the value of your car, among other changing factors.
Plus: How to Pay Off Your Car
If you’re planning a car purchase, and even if you’re in the middle of financing your car, a few tips from financial experts can help you save money (and hopefully guard against becoming “underwater“ on your loan).
Paying off a car is, of course, a highly individual process dependent on many different personal factors like credit score, financing rate, dollar amount down, and how much you can afford to pay each month. Still, there are some general guidelines that most people can follow:
- Financing: Experts we spoke to said they recommend auto loans not exceed 10% (for just the loan) to 20% (for the loan plus related expenses like gas and insurance) of a customer’s gross monthly income.
- Timeline: You should take the shortest term you can afford for two reasons: shorter terms come with lower interest rates and they allow vehicle equity to build faster. Experts we spoke to cited four or five years as the ideal balance of affordable monthly payments and reasonable total interest. If you have to spread your payments out over six years (72 months) or more to get monthly payments you can afford, you might want to consider a less expensive car.
“Your goal as a consumer is to decide what works best for your monthly budget so you can decrease the long term expense,” Poldberg says.
We asked three financial experts from around the country for their input about what type of loan over what time period a person living in Texas making $50,000 a year (the average statewide income) should expect to pay for a 2016 Honda CR-V (one of the most popular cars in the U.S.) most popular cars in the U.S.) for $23,000 (a little below the MSRP).
The Verdict(s): You’ll pay between $400 and $500 per month, depending on your credit and how quickly you can/wish to pay the vehicle back. Three ways of getting there:
- Poldberg: For this customer, the interest rate is going to be between 4.79% – 5.49% based on the US average credit score (687). Because most people finance their vehicles for five years, that would lock our customer into a rate of 4.99% for 60 months, making the monthly payment $433.93. During the term of the loan the customer would end up paying an extra $3,035.97 in interest, bringing the total out-of-pocket expense to $26,035.97. Financing your vehicle for the least amount of time possible will save hundreds or even thousands of dollars in the long run, but often people just want a lower monthly payment and disregard the long-term cost of the loan. If you financed that same CR-V for the maximum 75-month term, you’d end up paying $3,820.11 in interest (quite a bit more). But most consumers just look at the low monthly payment of $357.60 and think it’s a better deal.
- Rob Jupille, president of RTJ Financial in Santa Monica: Assuming a relatively “normal” level of other debt, when doing a budget, generally target your auto loan to be in the neighborhood of 10% of gross pay (excluding other auto related costs like gas, maintenance, insurance, etc.) and put at least 20% down to reduce the likelihood of being ‘upside down’ on your loan. This way, you’d look for a monthly car payment not exceeding $400 and we’d recommend shopping for a combination of interest rate and term to stay within that number.
- Harwood: Considering that your monthly car expense (including insurance, gas, etc.) should be no more than 20% of your take home pay, we can assume that an annual income of $50,000 translates to about $3,300 in take-home pay monthly after taxes. Budgeting around $250 for secondary auto expenses leaves room for a payment of around $450. For a consumer with decent credit, the $23,000 financed over 60 months at an interest rate of 6.9% lands the payment at $454 per month. (Of course everyone should pay off their car loan as quickly as they can, but this is a realistically affordable scenario.)
The bottom line: for a smart financing deal, pay the most you can for the shortest amount of time and after you’ve paid off your car loan, keep saving for your next car – or for a “rainy day.”
Originally contributed to Credit.com.