Paying Off Car Loans Early: Dangers

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.

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.

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.

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.