Making larger or more frequent payments may help you to pay your loan off faster and may help you to lower the total amount of interest you will pay. The important word here is “may”. Some auto loan agreements have provisions that negate any advantage you’d get from making larger or more frequent payments.
If the terms of your loan are favorable, you can gain significant advantages by making larger payments. You will have to check your loan agreement to determine whether or not this is the case. You’ll also have to decide whether paying off your car loan faster is a good decision for you. If the terms of your loan are not favorable you may be able to refinance with a loan that has better terms.
Why Would You Want to Make Larger Payments?
Auto loan terms in the US are getting longer. In 2009 only 26% of American car loans had terms over 6 years. In 2017 it was 42%. Those longer loan terms reduce monthly payments and can make a more expensive car seem more affordable.
These loans come with significant disadvantages, however, including:
- High-interest costs. Many longer-term loans carry relatively high-interest rates, and the longer the term of the loan the more time interest has to accumulate. Your total interest cost may rise considerably with a longer-term loan.
- Going underwater on your car loan. Cars depreciate fast, and a long-term loan, especially with a low down payment, often leaves you underwater on your loan: owing more on your car than it’s worth. That can make a car difficult to sell or refinance.
- Your loan term may outlast the warranty on your car. That can leave you facing expensive repair and maintenance costs while you’re still paying for your car.
If you have a long-term car loan and your income has increased since you took the loan out, you may be considering a possible solution to those problems: make larger or more frequent payments and pay the loan off ahead of schedule. That can get you lower interest costs and protect you from going underwater on your loan or overrunning your warranty.
Those are good reasons to pay your loan off early, but it’s not always so easy. Lenders may make it difficult to pay your loan ahead of schedule.
Check Your Loan Agreement
Paying off your loan faster and reducing your interest cost is good for you, but it’s not so good for your lender. Reducing your interest cost reduces their interest income.
Many car dealers earn as much or more from financing than they do from the profit margin on the cars they sell. These financers and other lenders may build terms into their loan agreements that discourage early payment.
Things to look for:
- Prepayment prohibitions. Some car loans completely prohibit early payment.
- Prepayment penalties. Some car loan agreements impose penalties for early payment. You will still get the loan off your back earlier, but the penalty is likely to offset any interest savings.
- Precomputed interest. Many car loans use simple interest: your interest is computed based on the outstanding balance at the time the interest is paid. If your loan uses simple interest it makes sense to pay it off early.
Other loans use precomputed interest: your interest is calculated at the start of the loan based on the interest rate on the term of the loan and will not change. If your loan uses precomputed interest you cannot lower your interest cost by paying it off early.
- Extra payments applied to interest, not principal. If you are making larger or more frequent payments, you want those payments to be applied to the loan’s principal, so you can pay the loan off early and reduce your interest cost.
Many lenders will apply those extra payments to your outstanding interest, which will not help you pay off your loan faster or lower your costs. Ask your lender whether your extra payment will be applied to interest or principal before you pay extra.
These features can make it impossible or impractical to pay your loan off ahead of schedule.
Check Your Finances
Even if your loan terms allow you to pay your loan off earlier, it may not always be the best decision. Consider these factors before boosting your payments.
- Will larger payments stress your budget? Before you commit money to larger or more frequent car payments, consider the impact on your overall budget. Can you really afford it? There are benefits to paying off a car loan early, but those benefits may be negated if you end up missing payments on other accounts.
- Could you be paying off higher-interest debt instead? If you have the capacity to pay off debt early it’s usually best to focus on higher-interest debts first. Car loans generally have fairly low-interest rates. If you have credit card debt you might want to use your extra money to pay that off first.
- Would you be better off using that money to build an emergency fund, or saving it for a down payment on a house, or investing it? Paying a car loan might help you, but are there other things you could do with that money that could help you more?
Getting rid of that car loan may seem like your top priority, but you have to decide whether it’s the best possible use of the resources you have available.
Think About Your Credit
Paying off a car loan early can affect your credit in several ways, and not all of them are positive. You could harm your credit, especially if you have a limited credit history with a small number of open accounts.
- Open accounts have a greater impact on your credit than closed ones. Lenders who view your credit report want to know how you’re handling the credit you have right now. An open car loan with consistent on-time payments makes a greater contribution to your credit than a paid off loan.
- Closing your car loan early could reduce the average age of your credit accounts. The average age of your open accounts has an impact on your credit. Higher average account age is a positive influence on your credit. Once your car loan is paid the account is closed and it no longer contributes to the average age of your open accounts.
- Paying off your car loan could affect your credit mix. Lenders like to see a mix of revolving credit, like credit cards, and installment credit, like your car loan. If you have no other installment loans, paying off your car loan could hurt your credit mix.
Consider the possible impact on your credit before you choose to pay a loan ahead of schedule. Ensure that by making a lump sum payment now that you won’t default on any other obligations.
How To Pay Off A Car Loan Early
You may review all of the potential drawbacks and obstacles and decide that you have the resources, your loan terms are favorable, and you want to pay your loan off faster. There can be good reasons for doing this. For example, if you are underwater on your loan you may want to sell the car before the loan is fully paid.
There are several ways to pay a car loan ahead of schedule. If your lender uses simple interest and is willing to apply extra payments to the loan’s principal, consider these options:
- Add more to your monthly payment. Consider rounding your payments up or adding a fixed sum to each monthly payment.
- Pay bi-weekly instead of monthly. You can split your monthly payment in half and make a payment every two weeks. Since there are 52 weeks in a year, you’ll be effectively making 13 months’ worth of payments instead of 12 every year.
- Make periodic extra payments. If you have extra money that comes in occasionally, like a tax return or bonus payments, you may choose to apply those payments to your car loan.
If your lender is not willing to put extra payments toward your loan’s principal, you still have options:
- Make a lump-sum payment. If you can afford it, the fastest way to take your car loan off the table is to pay it off in a single lump sum.
- Make your extra payments to a dedicated savings account and pay off the loan in a lump sum when you have enough. If you don’t have enough cash on hand to pay your loan off all at once, consider making your extra payments to a dedicated savings account, and making a lump sum payment when there’s enough money in that account.
Any of these methods will allow you to pay your car loan off early. You’ll have to choose the method that’s most appropriate for your situation.
If your lender refuses to accept principal-only payment or your loan contains restrictions that make early payment impractical, refinancing may be a solution. Refinancing involves getting a new loan with better terms and using it to pay off the old loan.
If you’re thinking of refinancing, consider these factors. Remember that the objective is to pay your loan off faster and save money on interest.
- Look for a shorter term. A shorter loan term will raise your monthly payments but will pay your loan off faster. It’s equivalent to making larger payments to pay your loan off early.
- Look for a lower interest rate. If your credit has improved since you got your first loan or you didn’t shop around enough before financing your car, you may be able to get a significantly lower interest rate. If you can get a lower rate and a shorter term refinancing could be an excellent option.
- Check your current loan for penalties. If your existing loan prohibits or penalizes early payment there may not be any point in refinancing.
Under the right circumstances, refinancing can get you substantially lower costs and better terms on your car loan. You’ll have to be careful and review the terms and fees of your new loan thoroughly to assure that you’re getting a better deal.
Making larger or more frequent payments on your car loan can pay off the loan faster and reduce your interest expense.
Before you decide to pay off your car loan early, check your loan agreement to make sure it’s feasible. Consider the possible impact on your finances and your credit.
If you decide to pay early, choose a suitable strategy, make your payments, and enjoy the financial freedom of life without car payments!