Car Loan Prepayment: Should You Do It?

Paying off your car loan early is a good idea if the interest rate on your loan is high and you have money Credit rating good. It’s not a good idea if the interest rate on your loan is low, your credit rating is low, or if paying could put your emergency fund at risk.

Suppose you are running out of business or have been hired tax refund And that you finally have enough money to pay off the car loan in full.

It’s a tempting move: You’ll have one less bill each month, save a few hundred dollars on interest payments, and finally get ownership of your car from the lender (which means you can give up). car insurance complete). It may be beneficial to pay off the car loan early.

But believe it or not, there are also huge benefits to sticking to your repayment schedule, even if you are able to pay off your loan in full.

Car Loan Prepayment: Should You Do It?
Car Loan Prepayment: Should You Do It?


A quick reminder of the basic principles of a car loan

Before we discuss the pros and cons of prepaying a car loan, let’s first review how car loan payments work.

The principal amount is the total amount that you are borrowing car purchase. So, if you buy a car for €30,000 and can afford to deposit €5,000, you will borrow the remaining €25,000. It’s a capital.

Interest is the “fee” that the lender charges for borrowing money. For lenders, interest is synonymous with income; Keep that in mind as we get into the nitty gritty.

In current and future loan documents, you may also experience two different types of interest:

Simple interest, used by the vast majority of lenders, is calculated based on the balance due on the due date. If you start making payments early or more frequently, or simply pay more than your monthly payment, the remaining interest should decrease in real time, allowing you to pay off your auto loan sooner.

All prepaid interest is calculated up front, and the total amount of interest you owe to the lender doesn’t change, even if you start paying off your auto loan sooner.

Whether you pay simple interest or prepaid interest will affect your ability to prepay.

In the case of simple interest, some lenders will charge you a fee to prepay your loan, giving up some of the expected income in the form of interest.

With prepaid interest, lenders tend to be less concerned about how quickly you can pay off your loan, since they charge the same amount of interest either way. For this reason, if you are considering this type of loan agreement, you should make sure that your lender offers you early repayment.

Most of the time, however, you’ll benefit from a simple interest plan – so that’s what we’ll focus on going forward.

If I pay extra on the car loan, does that increase go toward principal?

Auto loans are amortized, which means that part of your monthly payment goes to principal and part to interest.

So, if you pay $1,000 instead of $500 next month, where will the extra $500 go? Capital or interest?

Every lender is different, but many will just see the extra money, say “thank you,” and put more of it towards interest (ie pay themselves – same).

But you are allowed (and encouraged) to say to the lender, “Hey, please apply this to my principal so I can pay off my loan faster.”

Most lenders have a check box to indicate that you want the additional payments applied to your principal. Check your loan documents or contact them to find out how.

What happens in the event of early repayment of a car loan?

Usually, lenders won’t stop you from prepaying them. After all, any outstanding debt is a risk for them.

However, they may charge you a fee, called prepayment penalties.

What is the prepayment penalty?

A prepayment penalty is a commission that the lender charges you for repaying the loan before the end of the loan term (repayment period).

This may sound confusing or harmful, but it’s really just a matter of economics.

For example, if you take out a $35,000 loan at 5% interest for 36 months, you’ll end up paying about $2,750 in total interest.

If you get a file New job And by paying off your entire loan in just 18 months, you can save around €1,350 in interest. It’s a good thing!

But your lender will tell you that interest is our income – we are glad you paid us back what you borrowed, but somehow you stole £1000 from us.

Does paying off a car loan help creditworthiness?

Here’s another problem with getting a car loan that surprises some borrowers:

Paying off a car loan early can lower your credit score by a few points.

In fact, taking out an active auto loan can extend your credit history, diversify your credit mix, and show you good repayment habits. Combined, these factors account for 60% of your credit score.

When you close your account, it is still in your account credit report for 10 years, but you lose the opportunity to continue building your credit.

So, if you have 12 months of car payments remaining and plan to apply for another large loan in 24 months (MortgageAnd Student loanetc.), you might consider taking the opportunity to make 12 more payments on time, which will improve your credit rating before you apply for a much larger loan.

Of course, nothing is true for all borrowers. If paying off your auto loan improves your debt-to-equity ratio, it might be a good idea to put that extra money toward your auto loan.

Your debt ratio is the amount of your debt compared to your income. It indicates the percentage of your income that you set aside to pay off your debts.

How is the car loan paid off early?

Before deciding if prepaying a car loan is the right solution, let’s take a look at the four payment options available to you:

  • Pay the full lump sum
  • Pay a partial lump sum (eg €5,000 on a €10,000 balance).
  • Increase your monthly payments (eg 600€/month instead of 500€/month)
  • Increase the frequency of your payments (for example, 250 euros on the first and 15th days instead of 500 euros on the first day).

You can, of course, mix the two, adding $50 here and there and choosing to make payments every two weeks instead of monthly.

My last piece of advice on prepayments may seem obvious, but it’s often overlooked:

Contact your lender and discuss prepayment options.

At a minimum, a simple question like, “Can we discuss the best way to prepay the loan?” Some lenders can help you work out an optimal prepayment schedule that avoids fees.

What do you do instead of paying off your car loan early?

Depending on your personal financial situation, you may decide that prepaying your auto loan is not the best option.

Pay off other high-interest debts

If you have other debts, especially high-interest debts such as: Credit card Or personal loans, it may be best to reduce these balances and continue paying off the car loan as normal. This can save you more interest in the long run.

Earn your savings

If you still try Build your emergency fundYou can also put the extra money into a savings account.

It is recommended to save three to six months of expenses. If not yet, it may be wise to build them up before you start paying off your auto loan.

Start investing

If your savings are well invested, you can also use this money in Start investing with a broker like IQ Option. The earlier you start investing, the better. Compound interest is magic and the longer you stay in the markets the better.

Another option is to pay off your auto loan balance and then invest the old monthly payment.

Do you have to pay off the car loan in advance?

Let’s review some of the pros and cons of prepaying a car loan. I’ll also add a few other minor considerations that I haven’t mentioned yet.

Benefits of prepaying a car loan

The main benefit of prepaying a car loan is that it reduces your monthly debt payments. If you can pay off your car and get rid of your car payments, that saves quite a bit of money each month for other things.

  • you all Save a lot of money on interest payments
  • You are reducing your monthly payments.
  • You get your title faster because the lender technically owns your car until you pay it off.
  • It allows you to forgo full insurance, saving you money at the time of contract renewal.
  • It frees up capital to invest elsewhere
  • It removes the risk of “overdrafting” the loan (i.e. owing more than the value of the car).
  • Improves your debt ratio.

Disadvantages of prepaying a car loan

The main disadvantage of paying off a car loan early is that it takes money from you that you can use for other expenses, such as building up savings or Pay off other debts.

  • It risks diverting money from essential expenses, such as your emergency fund.
  • Prepayment penalties may result.
  • It can hurt your credit rating
  • It may make sense to invest the money from the refund in index funds (if the interest rate on your car loan is lower than, say, 4%).
  • The extra money can be used to pay down other high-interest debts.

Conclusion

Paying off a car loan early is usually a good decision

  • You can really afford it without hurting others financial difficulties.
  • You’ll save more money in interest than you would on prepaid penalties.
  • Your credit rating will still be high enough to meet your short-term borrowing goals, even after a small downgrade.
  • The interest rate on your loan is higher than the potential return on your investment.

But if you need the money to pay off more urgent matters, if your credit rating can still be improved, or if the interest rate on your loan is very low, it may be best not to overstay the auto loan.

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