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What if I pay extra on my car loan?

Published in Car Loan Management 4 mins read

Paying extra on your car loan is a financially sound strategy that can lead to substantial savings and help you become debt-free faster. When you make additional payments, you primarily benefit from reducing the total interest paid over the life of the loan and accelerating your payoff date.

Key Benefits of Making Extra Payments

Making extra payments beyond your minimum monthly obligation offers several advantages:

  • Significant Interest Savings: A portion of every car loan payment goes towards interest, especially in the early stages of the loan. By paying extra, you reduce your principal balance more quickly, meaning less interest accrues on the outstanding amount. This can save you hundreds, or even thousands, of dollars over the loan term.
  • Faster Loan Payoff: Accelerating your principal payments directly shortens the time it takes to pay off your loan. This means you'll own your car outright sooner, freeing up your monthly cash flow.
  • Build Equity Faster: As you reduce your principal, you build equity in your vehicle more rapidly. This can be beneficial if you plan to trade in or sell your car in the future.
  • Peace of Mind: Eliminating debt provides financial freedom and reduces stress, allowing you to reallocate those funds towards other financial goals, such as saving for a down payment on a home or retirement.

How Extra Payments Work

When you make an additional payment on your car loan, it's crucial to ensure the extra amount is applied directly to the principal balance. The principal is the original amount of money you borrowed. By reducing the principal, the interest that is calculated on the remaining balance also decreases, leading to the savings mentioned above. If not specified, some lenders might apply extra funds to future interest, which doesn't provide the same immediate benefit.

When Paying Extra is a Smart Move

It's a smart financial decision to pay extra on your car loan if you are in a stable financial position. This strategy is particularly effective when:

  • You have disposable income: If you have extra money left after covering all your essential expenses and contributing to your savings, directing it towards your car loan can be highly beneficial.
  • Your car loan interest rate is significant: The higher your interest rate, the more you stand to save by paying down the principal faster.
  • You want to reduce your overall debt: Paying off one debt can give you momentum and free up funds to tackle other financial goals.

When It Might Not Be the Best Idea

While generally beneficial, paying extra on your car loan might not be the absolute best strategy in every situation. The primary scenario where it might not be ideal is if you have higher-interest debt. For example, if you carry a balance on credit cards, their interest rates are typically much higher than car loan rates. In such cases, prioritizing the repayment of high-interest debt usually leads to greater overall financial savings.

Debt Type Typical Interest Rate Range Prioritization
Credit Card Debt 15% - 30%+ Highest
Personal Loans 6% - 36%+ High
Car Loans 3% - 10%+ Medium
Mortgage 3% - 7%+ Lower

Note: Interest rates are illustrative and vary widely based on creditworthiness and market conditions.

Practical Steps to Make Extra Payments

If you decide to make extra payments, follow these tips to ensure they are applied correctly and effectively:

  1. Contact Your Lender: Always communicate with your loan provider before making extra payments. Confirm their policy on extra payments and how to ensure they are applied to the principal.
  2. Specify "Principal Only": When making an additional payment, clearly indicate (verbally or in writing, if an option) that the extra amount should be applied solely to the principal balance.
  3. Use Online Portals or Mail: Many lenders allow you to make principal-only payments through their online portals. Alternatively, you can mail in a separate check with a note specifying "apply to principal only."
  4. Automate Extra Payments: Consider setting up an automatic extra payment each month, even if it's a small amount. Consistency compounds over time.
  5. Review Statements: Always review your loan statements to verify that the extra payments have been correctly applied to reduce your principal balance.

By strategically paying extra on your car loan, you can gain significant financial benefits, accelerating your journey to being debt-free. For more information on managing your auto loan, you can consult reputable financial resources like the Consumer Financial Protection Bureau.