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Should You Pay Off Your Car Early?

Have you got a car loan, and paying all of that interest to the bank or lender has become a hard pill to swallow? Maybe you have come into a little extra money, and you’re considering paying off your car early? Is this a good idea? Paying off your car early makes sense in most situations…but there are a couple of exceptions.

How Much Could Pre-Payment Save You?

First, let’s look at the benefits. The biggest reason to pay your car off early is to save money on the total interest paid, so let’s have a look at how much you can save in terms of an actual dollar amount. Assuming an original loan for $15,000 at 10% APR and a loan term of five years, you would pay a total of $4,122.34 in interest over the life of the loan. Pay the loan off one year early and you will save $861.28 in interest.

Adding an Additional Payment Each Year

If you are just starting a new loan and want to shave some time off of the repayment period, but do not think you will have the cash to pay a huge chunk of the principal at one time, try adding a bit to your monthly payment. In the above scenario, your monthly payment would be $318.71. If you divide that by 12, you get $26.56. By adding that to your payment each month you make an additional full payment each year, shaving five months off your repayment period and saving yourself $421.87 in total interest.

Exception 1:  Is This Your First Car Loan?

Now, for an instance where paying your car loan off early does not help you. If you are paying on your first car loan, or at least the first car loan as you try to rebuild your credit, you must make 18 on time payments on that loan or you will not see a significant boost to your credit score. That claim is based on information provided by FICO about their auto-enhanced credit score. After making that eighteenth payment, then you can pay your loan off whenever possible.

Exception 2:  Do You Have Prepayment Penalties?

There are three types of “prepayment penalties” that can quickly suck the benefits out of an early car loan payoff.

  1. Basic Prepayment Penalty:  in this case, the lender stipulates in the loan agreement that a certain percentage of the remaining balance is charged in the event of an early payoff. This is legal in most states–36 of them, at last count–and borrowers will have dig up their agreement, determine the percentage of the penalty, then compare with this with the numbers from an online calculator to determine if they will save any money by paying off their car early. In some cases, the total interest saved will not amount to the cost of the penalty.
  2. Rule of 78s:  this is a sneakier tactic wherein the early payments on your loan go toward paying down your interest, not your principal. In this way, by the time you want to pay off your car early, you may find that you have already paid much of the total interest, so you won’t save much by paying off the rest of it early. This is illegal on loans longer than 61 months, but most states do allow it on loans of 60 months or less.
  3. Pre-Computed Auto Loans:  in this case, your contract stipulates that you must pay not only the principal loan amount, but all of the interest as well. Even if you pay off the loan early, all of the interest will be owed to the lender, so you won’t save yourself a dime.

There is great article on The Dollar Stretcher about such penalties, but suffice it to say, it is important to ensure that such provisions are NOT in your auto loan agreement before you ever sign it, and before you decide to sink a load of cash into your vehicle. Fortunately, most of these penalties, while currently legal, are not all that common, and that means paying off your car early is usually a good idea if you have the funds to do it.

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