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There are very few feelings as satisfying as driving a new car off the lot and taking it home. That new-car smell, as you slip behind the wheel and shift into gear – is somewhat intoxicating. Buying a new ride is a financial milestone for any young adult and a necessary expense for families and businesses across the country.
A car expense is a line item that we’re all accustomed to seeing in our monthly budget. Considering the average loan term is either 3 or 5-years, some people with a distaste for debt, may want to pay off their car loan early to improve their monthly cash flow position.
With U.S consumers in more debt than at any point in history, it would seem like a prudent financial move to settle your debts early while you have the opportunity. However, unlike many other financial loan vehicles that reward you for paying off loans before the due date, you may get penalized for doing so with your car loan.
Before you make a mistake, it’s a wise move to have a financial planner go over the terms of your loan agreement before you make the purchase. IF you have the intention of paying down your loan earlier than the agreed terms, you need to know if you will incur any penalties.
We put together this brief guide to help you with paying down the debt on your car loan. Review our ideas and consult with your financial planner about how implementing this strategy could benefit your finances.
Understanding Interest and How It Affects Your Car Loan
When you take on a mortgage or some form of consumer debt, like a student loan, the lender typically calculates interest using compound interest.
Most of us are used to this interest model, but it’s not what most lenders use to calculate the interest you pay on your car loan. Lenders use the “simple interest” model when issuing car loans to their customers.
The compound model works by charging interest on the principal loan amount, as well as the accrued interest. As the interest balance increases with each month that passes, interest payments are calculated using the total amount due, including the outstanding interest on the loan.
Simple interest works by charging interest on the principal balance outstanding. This model allows the consumer to benefit from low-interest charges over the term of the loan, saving hundreds of dollars on the deal for the customer.
Occasionally, some lenders may use the precomputed interest model. In this case, the lender uses the loan term to calculate the total interest on the loan, and then they lock in that figure for the customer.
The precomputed interest model means that customers who do want to pay off their loan earlier do not benefit from preventing interest charges in the future. Therefore, this model offers no incentive to the customer to pay down the debt sooner than agreed in the finance contract.
Read: Complete Guide to Car Finance
Set Up Additional Principal Payments on Your Car Loan
Some car finance lenders don’t accept principal-only payments on your loan. When you make a payment, you’re paying the principal, along with outstanding interest. This model presents a conundrum for consumers that want to pay down their outstanding debt.
Should you receive a cash windfall, due to inheritance, winning a jackpot, or receiving your tax rebate – you might want to do something productive with the money and use it to pay off your car early.
However, the lender allocates your additional funds to the interest accrued since your last monthly payment. After settling this amount, the lender issues the rest of the funds toward paying down the principal.
As a result, the lender will issue you a statement with a zero balance for the following months – or a discounted balance depending on how much extra you paid toward your loan.
The model has its benefits and disadvantages for consumers. For many, it’s tempting to put your monthly payments on hold if your lender does not require an installment this month. The free cash flow in your budget may present finance for other opportunities you’ve had your eye on for some time.
Eventually, your payment returns to the minimum monthly amount, and you will need to resume your payments. This kind of payment holiday is a relief to many people, but it might not suit people that are trying to pay their loan off as quickly as possible.
What If the Lender Doesn’t Accept Principal-Only Payments?
Some states do not allow for principal only payments on your car loan. If your current lender does not offer this option, then you have the option of refinancing the loan with a lender that does offer the facility. Always ensure that you get written confirmation from the lender that they accept principal-only payments.
There are various auto-refinance companies online, and most of them are reasonably efficient at providing you with a quotation in 5 to 10-minutes after submitting your application.
If you don’t want to refinance, you can open a separate saving account for additional funds. When you have enough money saved to pay off the outstanding loan amount, settle with your lender.
Some Banks Make It Challenging to Pay off Your Loan Early
Banks and financial institutions make a considerable amount of their annual earnings from interest payments. The banks benefit by keeping you in debt for as long as possible while diversifying your credit into various vehicles such as a mortgage, car loan, personal loans, and a variety of other debt-based financial products. The longer you stay in debt – the more money they make.
It’s for this reason that many banks and lenders don’t like their customers to pay off their loans before the due date, as it ends up costing them money, while the customer wins. In banki8ng, the house must always win, and if you have an opportunity of saving – then you can bet your bottom dollar that they will do everything in their power to close that loophole.
Ways to Pay Off Your Car Loan Early
Now that you have a clear understanding of how interest works, and how challenging it can be to pay off your auto loan early – let’s look at a couple of strategies to help you pull it off, and cancel your debt as quickly as possible.
Negotiate Interest Payments
Many people are so happy that they get approved for finance on their new car, that they never stop to question the deal. For some odd reason, most of us think that the bank or lender is doing us a favor by giving us credit, and we are happy with the fact that we are eligible for finance.
However, the truth of the matter is that banks and lenders are more desperate than ever to find customers willing to take on more debt. When your bank sends over the agreements to sign, call into their finance department and ask to speak to the manager.
When you get hold of someone in a position of authority, such as a manager, then ask them to reduce the interest rate on your deal. Most of them will protest to your request, saying that it’s the best they can do with the interest rate. However, if you push, them – then they are likely to give you some discount on the initial offer.
If the manager refuses to budge on their offer, then hang up the phone and call a few other lenders. Ask them for a comparative quote, and you may be surprised to find how many other lenders are willing to beat your original quote.
Most lenders base their offering on your FICO credit score. If you have a good rating above 650 to 700, then you should have no issuers with finding below-average interest rates. Saving on interest when signing your loan agreement is even better than paying extra into your loan account, and it can save you hundreds of dollars in interest payments over the lifetime of the loan.
Refinance Your Interest Rate
As mentioned, lenders look at your credit score when calculating the interest rate on your loan facility. If you have an improvement in your credit score in the year or two since you signed your agreements, then you may be eligible for a rate review. Call into the finance department and ask them to adjust your interest rate based on your new risk profile.
If you find another financer offering a cheaper rate, you can refinance your outstanding loan with the new lender. The lender assumes the risk of the loan and allows you to either extend the loan terms or continue with your existing loan facility.
By refinancing your deal, you could benefit from improvement s to your FICO score in the duration of your contract score. You can also move your facility to a lender that allows for principal-only payments.
Use Bi-Monthly Loan Payments
If you work in a job where you receive bi-monthly paychecks on the 1st and 15th of the month, then adopt a bi-monthly payment plan with your lender. By selecting this payment strategy, you benefit from making an extra two payments during the course of a full year. This additional payment does not count as a principal-only payment, and it helps to reduce the total interest you pay during the loan term.
By paying every two weeks, that’s two weeks’ worth of interest you’re saving on your loan. While that may not seem like much difference on your loan repayment, it makes a massive difference during the course of the loan.
Renegotiate Insurance Premiums
Your insurer offers you another avenue to paying off your car early. When you purchase your car, lenders require that you take out insurance on the vehicle in case you crash it and write it off. This strategy allows the bank or lender to recover the outstanding loan amount from insurers.
However, your insurance company bases your monthly premium on your age, claims, and driver history, as well as your credit score. If it’s been a few years since you signed your loan agreement, then the chances are that your risk profile in these areas has reduced somewhat.
Therefore, your risk profile with insurers should be better, and they may offer you a discount on your monthly premium. If you call your insurer and they insist that there is no way they can help, then a call around for a few competitive quotes. Insurance companies are desperate for new business in today’s dwindling economy.
If you have a good driver and credit history, along with excellent credit – then you deserve a discount. Use the savings on your premiums to pay off your car loan faster.
Use Your Tax Refund or Pay Raise
If there’s one feeling that’s as satisfying as driving a new car off of the lot – it’s receiving a healthy tax rebate from the government. Instead of using your refund to fund a vacation, why not put it to good use and use it to pay off your car loan earlier?
Similarly, if you receive a pay raise at the office, then put the additional monthly funds toward paying off your loan. By using cash windfalls to reduce your debt, you’re able to significantly reduce the amount of interest you pay on the principal amount.
In Closing – When Should You Avoid Paying Off Your Car Loan Early?
The reason why we want to pay off loans early – is to minimize the total amount of interest we pay on the financing agreement. If you are in an advantageous financial position, and you are not struggling to pay your bills, then what do you do if you receive an extra $10,000 cash? If you already have a low-interest rate and insurance premium with your providers, is it worth paying off your loan?
In most circumstances, the answer is yes. However, if you have an opportunity to buy an asset of financial vehicle that receives an annual return that’s greater than the interest rate on your debt, then investing the funds would be a better move than paying off your loan. The additional income created by the asset will help you pay off your car loan, without taking money out of your pocket.
Stay Ahead of the Market with Benzinga Pro!
Want to trade like a pro? Benzinga Pro gives you the edge you need in today's fast-paced markets. Get real-time news, exclusive insights, and powerful tools trusted by professional traders:- Breaking market-moving stories before they hit mainstream media
- Live audio squawk for hands-free market updates
- Advanced stock scanner to spot promising trades
- Expert trade ideas and on-demand support
