With most loans, it's a good idea to pay them off early. It not only gives your budget some wiggle room but usually saves you money on interest and fees. But car loans are a little different. A lot of lenders put language in their contracts that prevent or penalize you for making principal-only payments.
In today's piece, we'll explore why that is and what you need to do to pay off your car loan early.
Why Do Lenders Make It So Hard to Pay Your Car Loan Off Early?
Banks are in the business of making money. By allowing you to pay things off ahead of time, they lose out on interest payments.
To avoid this, many lenders have started financing with precomputed interest. This means that they take the estimated interest on your original payment schedule and tack that on to your loan. So, no matter how quickly you pay off the loan, you'll end up paying the same amount. And, even if you make extra payments, that surplus money will go straight to interest. Using a bank or credit union is a good way to avoid this pitfall.
In some cases, lenders will go so far as to charge you a fee for paying a car off early. To avoid these penalties, make sure to read the fine print.
The Benefits of Paying Off Your Car Loan Early
Even with the deck stacked against you saving money on interest, there are other benefits of paying your car off early:
- It Lets You Start Saving for Your New Car: Just throw the money set aside for your old car payment into an interest-bearing account. This way, when your vehicle finally dies, you'll have a sizable down payment waiting.
- Paying Your Loan Off Early Can Reduce Insurance Costs: Financed cars need full-coverage. Once your vehicle is paid off, however, you can drop things like collision and comprehensive from your policy. But this can put you in a dire situation if something happens to your car. So, avoid doing it if you can.
- It Lowers Your Debt-to-Income (DTI) Ratio: Your DTI ratio is a big factor in financial health. It's used by banks and lenders to determine your ability to pay back the debt. If you're looking to get a mortgage or other big-ticket item, paying off your car can make it much easier.
3 Drawbacks of Paying Off Your Car Loan Early
If your great aunt Samantha leaves you $10,000 in her will, there are a few reasons you might not want to waste that money on your car:
- It Can Hurt Your Credit: Having an open account can bolster your credit scores. If you don't have any other accounts, it might be a good idea to keep the car loan open for a little while longer. This is especially true for people looking to establish credit.
- It's Not the Best Use of Your Money: The average credit card has an interest rate that's three times higher than the average car loan. So, it's usually a good idea to pay them off first. Even if you have no other debt, the money might be better off invested in a high-yield checking account. So do a few basic calculations before you throw those extra loonies on your 2017 Civic.
- The Bank Might Penalize You: While rare, prepayment penalties still exist. If you're unlucky enough to have one built into your loan, paying your car loan off early can put you in the poor house.
6 Things You Can Do to Free Yourself from That Car Payment a Little Sooner
You don't need a math degree to pay off your car a little early. All it takes is a bit of financial savvy and moderate levels of self-discipline. Though selling a kidney or an eye would certainly help, we're restraining our recommendations to things that don't cause bodily harm:
- Pay Half Your Payment Every Two Weeks: If your lender is willing to let you do this, you should. Though it seems stupid at first, paying this way lets you make 13 payments a year instead of 12. This allows you to pay off a 60-month loan in just 54-months.
- Round Up Your Payment Accounts: This is an easy and effortless way to knock a couple of months off your loan. Just pay your payment plus whatever it takes to get you to the next $50 or $100 increment. If your payment is $171 for example, just pay $200 each month. The more you pad this number, the quicker you'll pay your car off.
- Get a Side Hustle: If you're serious about getting out of debt, you might want to consider doing some independent work. Try walking dogs, shoveling snow, or freelance writing. You can then take the extra money and toss it on your vehicle's principal.
- Make One Extra Payment a Year: If you don't have the cash flow for two payments a month, just make one extra payment a year. Consider sourcing the money from your tax refund or savings account. If you'd prefer not to pay it in one lump sum, just divide your monthly payment by 12 and tack the resulting number onto your future monthly payments.
- Don't Skip Payments: Some lenders will let you skip your payments a couple of times a year. This offer is made most often around the holidays. But those missed payments don't disappear. They're just tacked on to the end of your loam. This means more interest, overall. So, do yourself a favor and toss these skip-a-pay offers in the bin.
- Refinance Your Loan: After a year or so, it might be a good time to discuss refinancing. Only do this if it nets you an earlier payoff date and a lower monthly payment. Otherwise, you'll just end up paying more in interest.