These days, it seems that car loan terms get longer and longer. Many people leave the dealership having signed for an 84-month loan, which is generally a bad idea. That said, you don’t have to stick to the loan term. You can pay more each month and pay off your auto loan before the loan term reaches its end. While paying more than your monthly minimum can sometimes be tough, there are major benefits to doing it. With so many people taking out longer loans, we thought it worth it to take a closer look at why paying down your car loan early is a smart practice.
Paying Early Reduces the Amount of Interest You Pay Overall
The biggest benefit of paying more money than the minimum each month and working towards paying off your loan early is that you’ll pay less interest over time. The additional money you pay towards the loan goes towards the principle, which is what your interest is calculated off of. This means if you make payments to lower the principle each month, you’ll pay less overall for the car once you have paid off the loan, and you won’t pay for the car for as many months either.
The Balance gives an excellent example using a $15,000 car loan. If your loan has a 7 percent interest rate over a five year loan period, you would end up paying $2,821 in interest by the end of the loan. That’s if you only paid the minimum payment. If, however, you pay an additional $50 per month you could reduce the amount of money you pay in interest by $487 and your car loan by 10 months. It definitely pays to pay in advance.
Once It’s Paid Off, You Can Rethink Your Auto Insurance
Car insurance is a major motoring expense for most of us. Quality car insurance isn’t cheap, and if you have a financed car, you’re likely paying for full coverage. Many lenders require you to keep full coverage on the car while you’re paying it off. However, once you pay off your auto loan, you can rethink your auto insurance a little.
In some cases, by the time you pay off your car loan, it might not make sense to keep full coverage on your vehicle. It depends on the vehicle you have, its value, and your personal preferences on coverage. We’re not suggesting you go all the way down to the state minimum coverage, but once you pay off your car, it’s smart to talk with your insurance agent to see if it makes sense to reduce coverage a little bit.
Lower Debt-to-Income Ratio and Peace of Mind
If you pay off your auto loan you’ll have a lower debt-to-income ratio. This ratio is important for if you’re interested in making a big purchase, like a house or another car. Lenders like to see people with a low debt-to-income ratio and good credit score because it shows they have plenty of funds to handle the loan they wish to take out.
Also, having a low debt-to-income ratio is just nice for your peace of mind. When you’re not worrying about how you’re going to make your car payments or pay off other debts, you’ll be less stressed and free to invest or spend money however you want. Paying down your car loan sooner than the established loan period means you’ll have more time to spend your money as you see fit.
How to Pay Your Car Loan Early
Paying off your car loan early sounds great, but it’s difficult to do. It’s hard to take the extra money you have and put it towards your car loan instead of using it for entertainment, clothing, or some other purchase you’d like to make. That said, in the long run, you’ll be better off, so here are some techniques you can use to pay down your auto loan early.
- Create a Budget That Supports Paying It Down Early
If you don’t have a monthly budget, you should create one. When creating your budget, make sure to account for paying more for your auto loan. If your loan payment is $300, consider budgeting for $350 or more.
- Round Payments Up
Car loan payments aren’t usually nice round numbers, so why not round up? If you have a car loan payment of $363 every month, consider rounding it up to the nearest hundred dollars and pay $400 a month, if possible.
- Make One Big Annual Payment
If you don’t want to make additional payments each month, consider setting extra money aside. Then at the end of the year, you can plop down a large sum on the loan. This is also a good idea if you get a big tax return or a bonus of some kind. Instead of spending it on a vacation or a new wardrobe, spend it on your car loan. Big payments like this can really change your monthly minimum payment.
Some Types of Auto Loans Won’t Benefit as Much From Early Payments
One scenario where it doesn’t really make sense to pay off your auto loan early is when you have a pre-computed auto loan. With this type of loan, the interest and principal portions of each payment period are predetermined. This means if you pay early, you won’t actually pay less interest. This eliminates one of the biggest advantages to paying early.
Also, some auto loans come with prepayment penalties. This means if you pay off your loan before the decided loan period, you would have to pay additional fees. In this case, it usually makes sense to just stick to your loan repayment schedule.
A smart practice in the case of pre-calculated loans and loans with prepayment penalties is to simply take that extra money you would like to put towards the loan into a savings account. That money can be used to save up for your next vehicle.