Can You Pay Extra on a Car Loan? And Should You?
Get clear guidance on whether paying extra on your car loan benefits your finances and how to properly apply additional funds.
It is common to wonder if making extra payments on a car loan is a good idea. This approach can offer several financial benefits, helping you manage your debt more effectively. Understanding how extra payments work and their implications is important for making an informed decision about your car loan.
Understanding Your Loan Agreement
Before making extra payments, review your car loan agreement. Some loan agreements may include prepayment penalties, which are fees charged for paying off a loan early. While less common with car loans, it is important to check your contract for such clauses to avoid offsetting savings.
Understand how your lender applies extra payments. With a simple interest loan, common for car loans, extra payments directly reduce the principal balance, leading to lower interest charges over time. In contrast, precomputed interest loans calculate the total interest upfront and distribute it evenly across the loan term, meaning extra payments may not significantly reduce the total interest paid.
Benefits of Paying Extra
Making additional payments on a car loan offers several financial advantages. A primary benefit is a reduction in the total interest paid over the life of the loan. By decreasing the principal balance faster, less interest accrues, leading to substantial savings.
Paying extra also results in a faster loan payoff, allowing you to achieve full ownership of your vehicle sooner. This accelerates the accumulation of equity in the car. An earlier payoff can also free up monthly cash flow, providing more financial flexibility for other goals. A lower debt burden and a history of over-minimum payments can positively influence your credit score over time.
How to Make Extra Payments
When deciding to make extra payments, communicating with your loan servicer is important. You should explicitly instruct the lender to apply any additional funds directly to the principal balance. This ensures the extra payment reduces the amount on which interest is calculated, rather than simply advancing your next due date.
Many lenders offer various methods for submitting extra payments, including online payment portals, phone payments, or mailing checks. Some may have an option to designate payments as “principal-only” directly through their online system. If mailing a check, writing “Principal Only” on the memo line, along with your account number, is a common practice. After making an extra payment, confirm with your lender that the funds were applied as intended to the principal.
Considerations Before Paying Extra
Before committing to extra car loan payments, assess your broader financial situation. Building a robust emergency savings fund is a primary financial goal. Financial experts recommend having at least $1,000 saved for unexpected expenses before focusing on accelerated debt payoff.
Prioritizing higher-interest debts, such as credit card balances, offers greater financial returns. The interest rates on such debts are significantly higher than car loan rates, meaning paying them off first can lead to more substantial interest savings. Other financial goals, like contributing to retirement accounts, especially to receive an employer match, take precedence. The impact of extra payments on a car loan is less significant if the interest rate is low, as the money might generate a better return elsewhere.