Is your monthly car payment putting a strain on your budget? Paying back your auto loan early can give you much-needed financial freedom and potentially save you hundreds (or thousands) of dollars in potential interest.
There are several effective strategies that you can use to prepay your car loan early, but think about potential penalties and the impact on your creditworthiness beforehand.
The Real Cost of a Car Loan
It’s no secret that cars are our worst big investment. Unlike homes, which typically increase in value over time, and education, which theoretically opens the door to higher earning opportunities, cars lose value over time. In fact, a new car depreciates as soon as you drive it out of the parking lot and loses 20 to 30% of its value in the first year.
That’s a big deal, especially given the average cost Americans will spend on new cars in 2021. According to KBB, that hard-to-swallow number is over $ 40,000, up more than 4% from 2020.
That means Americans are spending $ 40,000 on a car that will be worth between $ 28,000 and $ 32,000 in a year, which equates to a loss of $ 8,000 to $ 12,000.
But there’s more to consider than just the sticker price. In addition to sales tax (average 10.12% in 2020, although this varies by state) be prepared to pay interest on your car loan. Right now, the average auto loan interest rate (also known as the APR, although there is a difference) is over 4%.
The APR includes the interest rate in addition to other fees such as lending fees or mortgage insurance. You should use the APR, not the flat rate, when calculating your payment.
Your APR depends on the current market and Your creditworthiness. The better your credit rating, the lower your APR. If you have a weak credit rating and can put off buying a car, it is advisable to build your credit rating before applying for a loan.
In 2021, interest rates for 48-month (four-year) and 60-month (five-year) loans are expected to be between 4% and 5%.
Car loan calculator: an example
The interest on a car loan adds up. Let’s take the new $ 40,000 car as an example with a dealership fee of $ 995. For example, let’s say you are depositing $ 2,000 and have a clean 10% tax rate and 5% APR. You have agreed to pay off the loan over 60 months or five years. (The typical car loan has a term of three to seven years; the shorter the loan term, the higher the monthly payment.)
In this scenario, the total cost of the vehicle after taxes and dealer fees is $ 44,995 minus your down payment of $ 2,000. That leaves US $ 42,995 to finance. Given the 5% interest rate over 60 months, your monthly payment would be $ 811.37.
After 60 months, you ended up paying $ 50,682.20 (including down payment) on a car that costs just $ 44,995, including taxes and dealer fees. That means you’ve paid $ 5,687.20 in interest over five years.
And let’s just ignore the fact that the car you just paid more than $ 50,000 for is now worth $ 18,752.41 (average of.) Due to depreciation. 37% of the original cost after five years).
Use The Penny Hoarder’s car loan calculator to find out how much you are paying with real numbers that match your scenario.
This is how car loan rates work
Then repaying your car loan early when you can afford it seems a breeze. However, before you begin the strategy on how to prepay your car loan, you should do some research to determine what type of car loan you have.
In an ideal world, your loan is a simple interest loan. If you haven’t bought your car yet, you should only consider lenders who offer you a simple interest rate loan. This means that the interest is calculated entirely on the principal balance of the loan.
However, if your lender charges pre-calculated interest, they will calculate how much interest you will pay over the life of the loan and include that in your total balance. That said, even if you pay off your car early, the cash out offer includes all of the interest you would have paid if you had kept the loan open. In this case, there is absolutely no financial savings from paying off your car loan early.
Another element of your research loan are withdrawal fees. Withdrawal penalties are legal in 36 states and allow lenders to charge you a penalty (usually a fixed percentage of the remaining balance) for repaying your car loan early. In this case, it can be more expensive than you would have paid interest during the term of the car loan.
Will prepaying your car loan hurt your credit score?
Auto loan prepayment is unlikely to affect your creditworthiness, but it does could keep yourself from it Boost your credit score. Make regular, on-time payments approximately 35% of your FICO credit scorewhat makes it the most important factor. Paying a car loan monthly is a great way to show lenders that you are responsible for paying back your debts.
Additionally, lenders like to see a nice mix of loans (mortgage, Car loan, and credit cards are the big three). By keeping your auto loan open, you can also extend the duration of your loan history. Unless you have other open credit (like a credit card), it can be beneficial to keep your car loan open to help build your score if you ultimately plan to buy a home.
5 Early Repayment Strategies For Your Car Loan
If you have a simple fixed interest car loan, your loan has a good reputation, and your loan has no repayment penalties, it may be advisable to pay off your car loan early. Not only do they avoid spending a lot of money on interest, but they also give you back the financial freedom of hundreds of dollars in your monthly budget.
The best advice to early paying off a car loan: treat it like a mortgage. If you are a homeowner, you have probably heard that one extra (13th) payment of your mortgage capital each year can cut your loan by years. If you pay even more of the principal each year, then you can easily reduce your 30-year mortgage to 15 years – and you can use the PMI (private mortgage insurance) costs much earlier.
Of course, home loans are usually much larger than car loans, so the savings potential is much greater, but the logic works the same way with your car loan.
These strategies for early payment are all effective when done correctly:
1. Make one big extra payment every year
If you can count on your grandma making sure to put a big check in your Christmas card every year, don’t use that money on alcoholic eggnog (OK, maybe a bottle). Instead, apply it directly to your car loan as a lump sum.
If you have scheduled automatic payment online, you can log into your account and simply initiate a one-time payment. If you’re old-fashioned and paying by phone or email, just call your lender and let them know you’d like to make an additional one-time payment towards the headmaster.
Apply this logic to any non-budgeted (including non-budgeted) funds, such as B. a bonus at work or a tax refund.
2. Make half a payment every two weeks
Talk to your lender to see if you can switch to bi-weekly payments instead of monthly payments. If your lender allows you to pay half of your monthly loan amount every two weeks, you will end up making 26 half payments. Divide 26 by 2 and you get 13 full months of payment paid over 12 months. That means that by the end of the year, you essentially made an additional car payment.
Just check your budget first to make sure this type of payment plan is feasible.
3. Round up
Rounding up to the nearest $ 50 or even $ 100 if you can is a great way to add extra cash to capital each month. For example, if your monthly payment is $ 337, you could round up to $ 350 or even $ 400 to pay essentially an additional $ 13 or $ 63 per month. This will shorten the life of your loan by a few months.
If you have an automatic payment scheduled, log into your lending platform and see if you can add the extra funds to the capital every month so you don’t even have to think about it.
4. Resist the urge to skip a payment
Some lenders allow you to skip a payment or two a year. So nice of you, right? Not correct. They do so knowing that it will extend the life of your loan, which means they will reap even more of your hard-earned cash in interest fees.
Fight the urge to skip a payment unless you get into very tough times. You will end up paying more for doing this.
5. Refinance, but exercise caution
If you had bad credit when you bought your car and opted for a seven year loan to keep payments down, it might make sense to refinance yourself. Perhaps you’ve been in the lending business for two years, have a higher-paying job, and your credit history is in excellent shape. You could potentially refinance at a lower APR and build the loan over 36 months, saving you two years and a lot of money in interest.
But borrowers watch out: do not refinance yourself to get a lower monthly rate by extending a loan as you will end up paying more interest.
When not to pay off your car loan early
As we’ve seen, it doesn’t always make sense to prepay your car loan early. But there are more reasons to keep your horses than just cash penalties and prepaid interest.
Here are some other reasons Not to prepay your car loan:
- Lack of emergency savings. Bankrate reported in early 2021 that most Americans couldn’t afford a $ 1,000 emergency. Only 39% have enough to cover such an unexpected expense. If you are part of it 61% without a well-padded emergency fund, Prioritize depositing funds into a high-yield savings account to protect yourself and your family should the unthinkable happen. And it’s not just your family’s medical emergencies; In the event of a break-in, the cost of an unexpected car repair, or even a terrible drive to the vet when your dog eats something he won’t, you may need to cover a deductible from your rental insurance.
- Higher interest loans. If you have a decent interest rate on your car loan, though Drowning in credit card debt, focus on the debt with the highest interest rate. Credit cards historically have high teenage interest rates, so it makes most sense to pay off first. If you have no credit card debt but have a mortgage or student loan, compare these interest rates to your auto loan to see which interest rate makes the most sense to repay with additional funds.
- Missing credit history. If you are refusing to get a credit card and you don’t already own a home, a car loan is your best bet to help build your credit score. Keeping your car loan open can have a positive impact on your credit score.
- Investments. For most drivers, the annual percentage rate on auto loans is not dreadful. If you have additional funds and are thinking of paying off your low-interest car loan, consider instead Invest in your retirement savings or even buy a few stocks on your own. The average stock market return is around 10%. Of course you could end up to lose Money, but in general, when you invest and hold, expect your money to grow over time.
Timothy Moore is Senior Editor of WDW Magazine and a freelance writer and editor on topics such as personal finance, travel, careers, education, animal care, and automotive. He has been working in this field since 2012 with publications such as The Penny Hoarder, Debt.com, Ladders, Glassdoor, Aol and The News Wheel.
This article originally appeared on www.thepennyhoarder.com