If you secured financing for your vehicle purchase through a lender, you may find yourself wanting to pay off that loan sooner rather than later. Just like paying off your mortgage early, there are multiple benefits to making extra payments on a car loan. However, there are also potential disadvantages to consider. In this article, we will provide you with all the information you need to know about paying extra on a car loan.
How Can You Pay Extra on a Car Loan?
For most conventional auto loans, borrowers have the option to send in extra money with their monthly payments. It is important to specify that the additional funds should go towards paying the loan’s principal balance, which is the original amount borrowed. Otherwise, the lender will apply the funds to both the principal and interest portions of the loan.
If you used a personal loan to purchase a car, the same principle applies. Personal and auto loans are similar in structure as both are installment loans.
Another strategy to pay off your loan faster is to make biweekly payments. Instead of paying once a month, borrowers can make a half payment every two weeks. Since there are 52 weeks in a year, this results in 26 half payments or 13 full payments, one more than if they paid once a month.
The Advantages of Paying Down the Principal Faster
There are numerous advantages to making extra payments on a car loan and paying down the principal ahead of schedule.
Paying Off the Loan Faster
By putting more money towards the principal, you can eliminate the debt more quickly. This provides the benefit of freeing up more of your monthly cash flow, allowing you to redirect those funds towards other financial purposes such as paying off debt, investing, or saving for another major purchase.
Reducing Interest Payments
Paying off a loan early also means paying less interest over the lifetime of the loan. By paying the principal ahead of schedule, you eliminate the interest that would have accumulated over time. Depending on the loan amount and how quickly you pay it down, this could result in saving hundreds, or even thousands of dollars in interest payments.
Avoiding Being Upside-Down
If you financed the entire purchase of the vehicle, there is a possibility that you may end up “upside down” on the loan. Being upside down means owing more money on the loan than the asset is worth. This situation can arise if the vehicle is involved in an accident. When a borrower is upside down, the insurance company pays the vehicle’s current market value, which may be less than what is owed to the bank. Paying down the principal faster can help you avoid this predicament.
The Disadvantages of Paying Down the Principal Faster
While paying off your auto loan early can be a smart move, there are some potential pitfalls to be aware of.
Pre-Payment Fees
Although not all lenders impose these fees, some may place restrictions on borrowers paying off their loans ahead of schedule. It is essential to carefully review the fine print of your loan contract to ensure that this won’t be the case for you.
Vehicle Depreciation
Regardless of how quickly you pay off your car loan, your vehicle will continue to depreciate in value. According to automotive research company Kelley Blue Book, a car is likely to lose 60% of its original purchase price within the first five years. So, even if you pay off your car early, it will still experience depreciation.
Opportunity Cost of Funds
When making early principal payments, you essentially receive an investment return equivalent to the loan’s annual percentage rate (APR). If you were fortunate enough to secure a loan with a relatively low interest rate, paying it off early would yield a low return on investment. Consequently, it might be more advantageous to utilize your funds by investing or contributing more to tax-advantaged retirement accounts.
The Bottom Line
There are plenty of reasons to pay off your car loan as early as possible. From becoming debt-free to saving on interest payments, making extra payments towards the principal can offer significant financial benefits. However, it is crucial to consider the terms of your loan and APR, as that money might be put to better use elsewhere. Ultimately, borrowers should carefully weigh the pros and cons of each path and choose the option that makes the most sense for their unique situation.
