Homeowners are often told they can save tens of thousands of dollars in interest by paying extra to retire a mortgage early, but does the process work with cars?
Well the principle is the same, but the numbers are much smaller. When loan rates are especially low, as some are today, it might make more sense to use extra cash for other purposes like saving or a rainy-day fund.
With any type of loan, making extra payments - either as a lump sum or a boost in monthly payments - reduces the interest charges going forward. It’s as if the loan is recalculated by applying the interest rate and months remaining to the new, lower balance.
In fact, behind the scenes, that’s exactly what happens. With fixed-rate loans, the monthly payment stays the same, but more of each payment goes to pay off debt rather than interest, and the whole loan is paid off earlier.
As a rule of thumb, prepayments make sense if the interest rate on the loan is higher than the yield that could be earned elsewhere. Since the benefits of the prepayment are guaranteed and risk-free, the apples-to-apples comparison looks at alternatives like FDIC-insured bank savings, or safe short-term bonds, not risky investments like stocks.
Mortgage prepayments offer big savings because mortgages last for so long. Paying an extra $100 in the first month of a 5% mortgage will save you $5 per year in interest for 30 years, or $150.
But car loans never last that long. Paying an extra $100 at the start of a 48-month loan at 5% will save you just $20 over four years. Of course, saving always has some value, but if that $20 were invested it would grow over the two or three years that it might be tied up in your car loan.
What if you paid an extra $100 a month, starting after the first year? The calculator says you’d save $228 in interest and pay the loan off six months early.
Now suppose you came into a windfall and made a single $10,000 payment after two years, when the loan balance was down to only $10,500? You’d save $511 in interest and be free of payments in another two months.
These days it’s pretty hard to find a guaranteed fixed-income investment that pays 5%. The average 48-month certificate of deposit yields only 1.4%, according to the survey. On the other hand, the savings from extra payments on short-term car loans are not exactly jaw-dropping. Certainly, it would not make sense to put an extra $10,000 into your car loan if you didn’t have a rainy-day fund big enough to cover six to 12 months of living expenses.
Also, many car dealers and credit unions are beating the average loan rates cited by the survey. The search tool shows some lenders offering loans at less than 3%, and some manufacturers are offering even better deals.
Just be sure a super low rate is not an alternative to some other incentive, like cash back, that might be more valuable. Weigh the alternatives with the Auto Rebate vs. Low Interest Financing Calculator.
—For more ways to save, spend, invest and borrow, visit MainStreet.com.