Paying off a loan early can reduce your overall interest payments, but depending on the terms of your loan, you could face prepayment penalties.
If you have a lump sum of cash, paying off your
car loanin full can look appealing. But auto lenders tend to make it difficult to make principal-only payments because it’s not profitable for them—the interest is where they make their money!
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How car loan interest is calculated
To understand why you might want to pay off your loan early (and why lenders don’t want you to!), you need to understand a bit about interest. There are two main types:
- Simple interest is charged only on the principal balance of your loan.
- Compound interest accumulates based on the principal amount plus whatever interest you have accrued (essentially, interest is charged on your interest).
There’s also something called precomputed interest. This is when a lender does the
interest calculationat the time you take out the loan. You can pay off the loan early or make extra payments, but the amount of interest is set in stone and will not change.
Interest is calculated as a percentage of your full loan amount. It’s normally called an APR, or annual percentage rate.
Benefits of paying off your car loan early
There are a few great benefits of getting that loan paid early.
Save on interest
If your loan has simple interest or compound interest, paying off your loan early means you could benefit from paying less overall interest. A shorter pay-back period allows less time for interest to accumulate—which means more money in your wallet.
A 5-year, $20,000 loan at a 5%
APRwould normally cost you $2,645 in interest by the end of the loan term. But paying it off just a year early would save you more than $500 in interest charges! For larger loans and longer terms, the savings could run into the thousands.
Free up money for other expenses
While paying off your loan obviously requires a lump sum of money upfront, it frees up funds in the long term that you can use for other expenses. Once your loan is paid off, you can start applying that monthly payment amount to a mortgage, a vacation, paying off a debt, or beefing up your savings account.
Avoid ending your loan upside down
With long-term loans, there’s a possibility you could accumulate so much interest that you end up owing more than the car is worth. This is called being "
upside down." Paying off your loan early allows you to avoid this situation.
Key Takeaway Paying off your car loan early can result in serious interest savings and free up money for you to save or put towards other expenses.
Is it good to pay off a car loan early?
In some cases, it might not make financial sense to pay off your loan early. Here’s when you might consider keeping those monthly payments.
If your contract includes precomputed interest, an early payoff won’t save you any money because the interest is built into your payments. You may even get hit with prepayment penalties if your loan agreement includes a fee for early payoff.
Your financial situation
You’ll also want to consider your overall financial situation. If you have another debt with a higher interest rate, it may make more sense to pay that off first. Credit cards, for example, tend to have far higher APRs than car loans. In the long run, this strategy will save you more money on accrued interest.
If you’re concerned about
your credit score, maintaining an open line of credit and making regular payments over time can have a better impact on your credit score than a quick and full payoff. Consider keeping your loan open if you want to slowly and securely build your credit history.
Key Takeaway If you’re considering paying off your car loan in full, review your budget and the loan terms to see whether it makes good financial sense.
How to pay off your auto loan early
If paying off your loan early makes sense, start by contacting the lender to discuss your plan. You have two options:
- A lump-sum payment
- Increasing your payments to more than the minimum payment amount to shorten payoff time
But be careful! Make sure you tell the lender to apply your payments to the principal amount, as this is the only technique to actually reduce your payoff time.
If your current lender will not accept principal-only payments or if you want to reduce your loan term or get a better APR, refinancing might also be an option.
And if you want to keep the savings coming, look at your insurance next. Perhaps you’re not getting quite as good a deal as you initially thought! Comparing insurance quotes can find you something cheaper.
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