With most loans, if you pay them off sooner than planned, you pay less in interest (assuming it has no prepayment penalties). But that may not be true for your car loan.
Some lenders have language in their contracts that actually prevents you from paying down the principal earlier than planned. Here we’ll go over what you need to know before you try to pay off your car loan early.
Why do lenders make it difficult to pay off your car loan early? Put simply, it’s because those lenders want to make money, and paying down the principal early deprives them of interest payments.
How car loans calculate interest
Most loans (for example, a mortgage or a student loan) charge compound interest. Many car loans, however, compute interest differently—they charge simple interest.
What’s the difference between compound interest and simple interest?
Compound interest is charged on both the principal and accrued interest amount. That means that as your interest balance increases with each day that the loan is outstanding, interest is also charged on that balance.
Simple interest is calculated based only on the principal balance outstanding on the loan.
The good news is that simple interest results in a lower interest charge over the life of the loan. In fact, the simple interest calculation can save several hundred dollars over the full term of the loan.
Related: Car Affordability Calculator
Precomputed interest on a car loan
Car lenders also sometimes use something called precomputed interest. Lenders use your original payment schedule (i.e. how long you’ll take to pay off the loan) to calculate the total interest on the loan, and that total interest is set.
Even if you pay your loan off sooner, or make extra payments, the amount of total interest you pay does not change.
The amount of interest you pay using precomputed interest will be the same as it is for simple interest if you make all your payments according to the schedule. If you make additional principal-only payments under this type of loan, the lender may first apply the extra payment to the interest balance precomputed over the life of the loan, rather than to the principal balance.
When you want to make principal-only payments, you must contact the lender and determine what the process is.
If the lender is not accommodating, then you may have to consider refinancing. If you refinance the loan, verify that the new lender uses either compound interest or simple interest. And specifically avoid those lenders that use pre-calculated interest.
As a general rule, banks and credit unions tend to use compound interest. But auto loan finance companies will be more likely to use precomputed interest, or simple interest.
Setting up extra principal payments on a car loan
Some car lenders will not accept principal only payments.
If you use this calculator and set it up for extra payments every month, it shows you’ll pay less in overall finance charges.
So what’s the deal? In the way of banks, Ally is being exceptionally cagey about how its loan actually works. You can pay it off early, and you can save in interest. But Ally will never take a payment and automatically apply it to the principal. It will first take care of any other outstanding charges, including interest.
When you pay your car loan, you’re paying both part of the principal and also any interest that has accrued in the time since your last payment. So, if you make your regular payment as usual, then two weeks later get an unexpected windfall and want to throw that at your balance, Ally will first put it toward the two weeks of interest that’s accrued since your last official payment. Then, whatever’s left over will apply to your principal.
Once you’ve made an extra payment, the bank will simply reduce the amount of your next payment, possibly to zero. Or they’ll change the date your next payment is due, instead of simply applying amount to the balance and charging you the next month as usual.
The temptation here, of course, is to look at that minimum due ($0!) and simply not pay for the next month, or the next two or three months, until that minimum is back up, which means eventually your payment schedule will return to normal. You won’t pay your loan off early; you’ll just have made payments ahead of schedule, and then taken a brief hiatus from paying.
If your lender won’t accept principal-only payments
If your lender will not accept principal only payments, you have two choices:
- Refinance the loan with a lender who will accept principal-only payments. Make sure that you get written verification before doing the refinance. You can get multiple different no-obligation auto loan refinancing quotes from Monevo online with just one simple application.
- Make your additional principal payments to a dedicated savings account, and when the savings account balance is high enough, pay off the loan completely.
But before you do any of that, check to see what the laws are in your state in regard to principal-only car-loan payments. If your lender doesn’t allow it, but state law does, you can cite the law and require that they make a provision to accept the payments.
Related: Peer-to-Peer Auto Loans
Other banks make principal-only payments difficult
To maximize the amount of interest you pay, lenders make you jump through hoops to make additional principal payments. For example, some may require that you write a separate check—in addition to the regular monthly car payment—for principal. Some banks even require that additional principal payments be sent to a completely different address.
Consumerist has reported that Chase Bank required you to send a paper check to a specific address for the payment to be applied to the principal. Otherwise, they simply considered additional payments to be early payments, rather than truly an “extra” payment. It seems they’ve since changed their ways. You can also now simply check a box marked “principal reduction”.
As you can see, car loans aren’t quite as simple as they seem. Though it may seem counterintuitive, not all car loan lenders want you to pay off your loan ahead of schedule. After all, if you do, they will lose the income that they would earn on the payments that you make. For that reason, you can expect an obstacle or two to discourage you from making principal only payments.
The next time you buy a car and need to take a car loan, pay close attention to the interest calculation method. If it will be anything other than simple interest, or compound interest, look for a different loan or lender.