There are many benefits to paying off a car loan early, and depending on your finances, it may be the right thing for you to do. You can pay your loans off early by making additional monthly car loan payments, increasing the amount of principal you pay each month or paying a large lump sum, but is it the right thing to do? Not all loans can be paid off early so you want to be sure that there isn't a penalty for early payoff. If there is, you may actually end up costing yourself more money in the long run. Let's take a look at the advantages of paying off your loan early.
- The main reason to pay a loan off early is to save money, specifically on the monthly interest. You could save yourself a great deal of money by paying the loan off early, however you need to consider that if you take $12,000 out of an account that is generating interest in order to pay your car off early you lose any interest that would have been gained while that money sat in the bank. Some simple math can tell you what decision will make more money for you in the long run. Additionally, by paying off your car early you may be emptying your savings and that could have an impact at a later date.
- Paying off loans early generally improves your credit score. This can obviously help you in the future if you need to secure another loan. Credit scores also improve when you are making on time monthly payments so in most cases you want to pay 12 to 24 months of payments before paying off the balance in order to ensure you maximize the amount of credit gain.
- Without a car payment you free up much more cash flow every month. This can be important if you are on a tight budget or need the money for another expense.
- Interest on your auto loan is not tax deductible but interest on other loans, such as home equity loans, is. For some people it may be a good idea to take a home equity loan to pay off their car early. Of course this is only moving your payment and debt obligation to a different lender, but you could potentially get a lower interest rate to go with the tax deduction. Be warned that most lines of home equity credit have variable interest rates and while they may qualify for a tax deduction they could increase to the point where you end up paying more for your car than you would had you kept the auto loan.
- If your car is older, or in poor condition, you could save a lot of money on your car insurance by paying off loan. Lenders require that you carry a certain level of comprehensive and collision insurance on any vehicle that has a lien on it. However, if you pay your vehicle off early you can reduce the amount of coverage on it and save yourself a great deal of money every month. Everything from the deductible, glass coverage and liability coverage can potentially be changed.
Paying off auto loans early can be beneficial if you have the money for it, but your personal financial situation will determine what will work for you and what won't.
The Dangers of Paying Off Car Loans Early
There are dangers associated with paying off a car loan early. The loan rate is based on the retirement of the debt over time, usually between 36 to 60 months. This calculation takes into account the amount of interest that the lender will earn during the loan period. Paying the loan off before the end of the term deprives the lender of that future income stream.
Present Dollars versus Future Dollars
There is an argument to be made regarding the value of money today versus some future point. For example, which is more valuable, $1 today or received 2 years from now? Based on the time-value of money, the answer is $1 today. The effect that inflation, a general rise in prices, has on money over time reduces its purchasing power. At an annual rate of inflation of 10%, a dollar received 2 years from now is worth 82 cents.
This makes sense however the way the loan is financed. It takes into account the affect of inflation, thus inflating the payment over time. The larger portion of the payment in the early years is the growth or interest, and over time, the principal amount. Paying the loan back early results in the deprivation of that growth for the lender.
Lump Sum Payment
Making a lump-sum payment does not make sense because of the finance charges involved with the loan. A person with the ability to make a lump-sum payment for the purchase of vehicle should have delayed the purchase decision until such time that they could simply buy the vehicle with cash.
To account for early payment, such as a lump sum, lenders will impose an early payment or prepayment penalty. This penalty is equal to the opportunity cost loss for the lender by receiving the loan amount earlier than anticipated. It may seem desirous from the borrower to pay a loan off sooner, but in the end, it may end up costing more.
Alternative to Early Payment
An alternative to incurring a prepayment penalty by paying the loan early is the use of a defeasance account. This account allows you to deposit the full value of the loan into a separate account and through a systematic monthly withdrawal, the money in defeasance will pay off the debt. The lender benefits by knowing that the loan proceeds are in safekeeping and that their earning schedule is uninterrupted. You benefit because the account frees up the debit balance and improves your credit rating.
Why Should I Pay Off My Car Loan Early?
If you're looking at paying off a car loan want to figure out the best strategies for saving money in the long run, your best bet is to look at the interest rate and overall payments, not just the size of the monthly payment. Dealers and other financiers like to do a little sleight of hand to convince you that making "low payments" is a winning situation, but with a closer look, you'll see that there is a right and wrong way to set up a car loan agreement.
Overall Best Way to Pay Off a Car Loan
The best way to pay off car loans is simple: borrow as little as possible, and pay it off as soon as possible. Doing this cuts way down on the interest that you pay over the term of the loan. The more you pay up front, the less you have to borrow, and the less you will be paying interest. By the same token, if you receive a lump sum of money after the deal is made, you'll want to pay off the car and keep more money in your pocket for future purposes.
Exceptions to the Rule: Car Loans and Windfalls
One exception to the general rule is when you know for sure that you'll be getting a lot more money some months after the car financing agreement is made. With some kinds of "balloon payments" and similar deals, you might be able to get a lower interest rate for up front payments. However, this is only a good deal if you can pay off the car loan balance before higher interest rates kick in. Otherwise, you're best off going with a large down payment and a deal that includes no prepayment penalties.