If you worked with a lender to get financing for your vehicle purchase, at some point you might want to pay that loan off sooner rather than later. Just like paying your mortgage off early, there can be several benefits. However, there may also be some potential disadvantages. Here’s what you need to know about paying extra on a car loan.
How Do You Pay Extra on a Car Loan?
With most conventional auto loans, a borrower can send in extra money with their monthly payments. When they do this, they should specify that the additional funds should go toward paying the loan’s principal balance, that is, the amount that was originally borrowed. Otherwise, the lender will spread it across both the principal and interest.
The same would be true if you used a personal loan to buy a car. Personal and auto loans are similar since they are both structured as installment loans.
Another paydown acceleration strategy is to make biweekly payments. This is an arrangement where instead of paying once a month, the borrower makes a half payment every two weeks. Since there are 52 weeks in a year, this will result in 26 half payments or 13 full payments, one more than the twelve that would be made if they paid once per month.
The Advantages of Paying Down the Principal Faster
There are many good reasons to make extra payments on a car loan and paying down the principal ahead of schedule.
Paying Off the Loan Faster
The more money you put toward the principal, the quicker you’ll eliminate the debt. This is very desirable because it frees up more of your monthly cash flow, and you can redirect those funds toward other financial purposes like paying off debt, investing, or saving for another large purchase.
Spending Less Interest
Paying off a loan early will also reduce how much interest you’ll pay over the lifetime of the loan. Because the principal and interest payments are spread out over time, paying the principal ahead of schedule eliminates the interest that would have accrued later. Depending on the size of the loan and how quickly you pay it down , this could result in saving hundreds or maybe thousands of dollars in interest.
Avoid Being Upside-Down
Chances are that if you financed the entire purchase of the vehicle, you may end up being what’s called “upside down.” Upside down is when you owe more money on the loan than the asset is worth.
A typical scenario when this can happen is if the vehicle is in an auto accident. When someone is upside down, the insurance company pays the vehicle’s current market value, and it’s very likely that amount is less than what the car owner owes to the bank. This leaves the owner having to pay the difference. Paying the principal down quicker can help you avoid this situation.
The Disadvantages of Paying Down the Principal Faster
While paying off your auto loan early can be a good idea, there are some potential pitfalls to watch out for.
Pre-Payment Fees
Not all lenders do this, but some may restrict borrowers from paying the loan off ahead of schedule. Double-check the fine print of your loan contract to ensure this won’t be the case for you.
Vehicle Depreciation
Unfortunately, no matter how quickly you pay off your car loan, it doesn’t change the fact that your vehicle is constantly losing 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 still loses value.
The Money Could Be Used More Efficiently
Whenever someone makes early principal payments, they’re essentially getting an investment return that’s equivalent to the APR of the loan. If you were fortunate enough to borrow money when interest rates on loans were relatively low, paying one off early would yield a low return on investment. Therefore, your money may be put to better use by investing it or contributing more to tax-advantaged retirement accounts.
The Bottom Line
There are a lot of good reasons to pay off your loan as early as possible. From becoming debt-free to saving money on interest, extra payments towards the principal can be very financially beneficial. However, depending on the loan terms or APR, this money could also have better uses. Ultimately, borrowers should weigh the pros and cons of each path and choose the one that makes the most sense for their situation.
Source:
https://www.lendingtree.com/auto/how-much-do-new-cars-depreciate/
https://www.kbb.com/car-advice/how-to-beat-car-depreciation/
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