Should I Make Extra Payments on my Car Loan?
Paying off your car loan early can save you money on interest, but it's not always a beneficial financial choice. To pay the minimum cost for your car loan over the loan term, here's what you'll need to know.
Should you make extra payments?
Deciding whether you rid yourself of debt by paying out your car loan early with extra payments is a positive choice that demonstrates your aversion to debt.
But will you always be financially better off by taking this route, or should you invest the extra money elsewhere?
This will depend on what type of car loan you've taken out, and the specific terms and conditions set by your lender. You'll need to read your car loan contract to find out. Here's what you'll need to look for:
When is it good to make extra payments?
You will save money by making extra payments on your car loan when:
- There's no penalty fee for extra payments
- You can make extra payments within a fixed limit
- No early payout fee applies to your loan contract
- Interest is charged monthly as 'simple interest'
Before you start making extra payments on your car loan, make sure that the interest you will save by paying extra will be greater than any fees that you might incur.
How is your interest calculated?
Most car loans are calculated using 'simple interest'. This means that the interest paid each month is based on the outstanding balance of the loan.
The earlier you pay back a 'simple interest' car loan, reducing the loan balance with each extra payment, then you'll reduce the amount of interest charged each month.
Make sure your extra payments go straight to reduce the loan balance.
Before deciding to make extra car loan payments, ensure that your payment goes directly to reducing the principal on the car loan, not towards interest payments.
What are the benefits of early payout?
While the savings you'll make by paying out your car loan early might not be huge, the real advantage to paying out the loan is that you'll free up the amount you're putting towards loan payments each month sooner.
This is called the 'opportunity cost' of borrowing money. It basically means that while you are using part of your income for payments for one thing, then you don't have income available for other things that you'd like to do.
Paying your loan early gives you more flexibility to cope with sudden life changes and the freedom to make other financial plans and investments.
If paying off your car loan on your own schedule rather than one imposed by the lender is important to you, then make sure that you select a loan that doesn't have penalties for early payment. Ask a lending manager for advice on which lenders offer this option.
When is making extra payments a bad idea?
Most car loans are 'simple interest' car loans, which means the interest is calculated each month, based on the outstanding loan balance at the time. However, some car loan lenders will calculate the interest at the beginning of the loan term.
Some car loans will charge 'simple add-on interest' where the total interest is calculated at the beginning of the loan term and added to the total amount owing.
If your loan has a 'simple add-on interest' structure, then there's no advantage to paying out the loan early. This is because the when the interest is added to the total amount at the beginning of the loan term, paying extra won't reduce the total amount of interest you'll pay back.
In this case, you'd be better off putting extra money you have towards another investment that can earn you interest, and stick to your scheduled car loan repayments. Also, refinancing a simple add-on interest loan won't reduce your costs, as you've already committed to paying the full interest amount.
Always review your loan contract before making a decision so you're sure about what your decision will mean.
Jim's car loan repayments are $471 each month. If he pays out his car loan early, he could invest this amount. Assuming a 6% interest rate, after 10 years Jim will have $77,000.
What to do before paying out your car loan:
In some circumstances, such as if your car has been written off, or you are refinancing your car loan to a better option, you'll need to pay out the entire remaining balance in a single payment.
Here's what you should do before proceeding.
1. Contact the lender to find out your break costs and termination fee
Some lenders will charge a fee for finalising your car loan before the anticipated date. This might be calculated based on the number of months remaining on the loan term, or it might be a fixed fee.
Some lenders will charge both a fixed termination fee and break costs calculated based on how long remains on your contractual loan term. Just make sure that you'll end up in front after paying these costs.
2. Write down the name of the person you speak to
Each conversation with your lender will be recorded, so if you negotiate a reduced termination fee with one person, and have to deal with a different person when you finalise the loan, make sure you write down the name of the person you're speaking to each time.
3. Request a payout figure in writing
If you are refinancing your car loan or making an insurance payout, you'll need the payout amount for your current loan balance in writing.
When you request a payout figure, you might need to provide the date you'll repay the remaining balance so that accurate calculations can be made regarding how much interest will be applied. Car loans usually have fixed interest rates, so there should be no problems calculating the payout figure once you have a date.
If you're considering refinancing or you want a car loan with easy early payment options, get advice from a professional who can help you to work out if you're better off paying out the loan early, and break down all the fees to put you in the best financial position.