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Has your financial situation changed since you bought your car? With two-thirds of new car loans now lasting six years or more, according to Experian data, there's a good chance it has. Perhaps you bought your car flush with the excitement of landing your first entry-level job. Now you're a manager with a bigger salary and an annual bonus. With extra cash on hand, should you pay extra on your car payment? You can pay more on your car payment in many cases, but before doing so, make sure you fully understand the effects it will have on your auto loan, your credit score and your personal finances.
How Paying Extra on Your Car Loan Payments Works
Before you schedule that extra payment on your car loan, you need to find out whether your lender applies the payments to your loan principal or to the interest.
Applying extra payments directly to the principal (that is, the amount of money you borrowed) is ideal because it reduces both the amount you owe and your total interest. (The exception: If your loan has precomputed interest, meaning the total interest was calculated and fixed based on the term of your loan, you'll pay the same amount of interest no matter how quickly you pay off the loan.)
However, many lenders don't apply your extra payment amount directly to the principal. Instead, they'll apply it first to the additional interest accrued since your last payment, and only then to the principal.
What if you make a whole extra payment instead of just adding a little bit more to your monthly payment? Unfortunately, many auto lenders will treat this as an early payment of your next bill instead of applying it to the principal.
If you want to make sure the extra payment will be applied directly to your loan principal, find out exactly what your lender requires to do so. You may need to specify your wishes in writing, check a box online or even mail your extra principal payments to a different address.
Benefits of Paying More on Your Car Payment
There are a couple of reasons you might want to pay extra on your car payment each month.
- You'll pay less interest overall. If you have a 60-month, 72-month or even 84-month auto loan, you'll pay quite a bit in interest over the loan term. As long as your loan doesn't have precomputed interest, paying extra can help reduce the total amount of interest you'll pay.
- You'll pay off your loan faster. The faster you can pay off your loan, the sooner you'll have extra cash to toward other needs, such as a down payment for your next car, paying off credit card debt or saving for your summer vacation.
What to Consider Before Paying Extra
Before you pay extra on your car loan, however, it's important to consider these questions:
- Does your lender allow extra payments? Some auto lenders prohibit early repayment altogether. Others charge prepayment penalties, which can eliminate any savings from making extra payments. Check with your lender to find out what your loan terms allow.
- Do you have other, higher interest debt? In general, auto loan interest rates are fairly low compared with, say, credit card debt. For example, the average credit card interest rate is currently 17.86%, while the average interest rate for a 60-month new-car loan is 4.73%. If you have extra money, use it to pay down high interest debt before tackling low interest debt.
- How will making extra car payments affect your budget? Make sure the extra payments won't stretch your budget to the breaking point. If you end up short of cash, you might be tempted to put expenses on your credit card, creating high interest debt.
- Could this money be put to better use? Depending on your current needs and future plans, there may be more productive uses for your money than paying extra on a car loan. For instance, you might want to increase your 401(k) contribution, build up an emergency savings fund or start saving for a down payment on a home.
How Paying More on Your Car Payment Affects Your Credit
Paying more on your car loan affects your credit score—and not necessarily in a positive way. Here's what you need to know.
If you make an extra car loan payment once or twice, it probably won't impact your credit score at all. However, if you consistently make extra payments and pay off your car loan early, it can actually hurt your credit score—especially if you're just starting to build credit, don't have many credit accounts or are trying to improve your credit score.
Once your loan is paid off, the account will be closed. Although closed accounts may show you successfully managed credit in the past, open credit accounts have a greater impact on your credit score because they show lenders how well you're managing credit in the present. Your credit score also takes into account how long you have been using credit, so if your auto loan is your oldest credit account, closing it can hurt your credit score.
Closing your auto loan may also reduce your credit mix—that is, how many different types of credit you have. Car loans, mortgages and student loans are installment loans, meaning you borrow a fixed amount and pay it back in monthly installments. Most credit cards are revolving credit, meaning your payments are based on how much of your available credit you use. Having a diverse mix of both installment and revolving credit can help to boost your credit score. If your car loan is your only installment loan, it's better to keep it open than to close it early. Learn more about what affects your credit score.
Finally, paying off your car loan could hurt your credit score if all of your other credit accounts have high balances. That's because credit utilization ratio (how much of your available credit you actually use) is a factor in your credit score. Find out more about how paying off a car loan early can hurt your credit score.
Make the Smart Decision
As you can see, there's a lot to consider before you decide to pay more on your car payments, including your lender's terms, your financial needs and your credit score. To check your credit mix, credit utilization ratio and credit history, you can get a free credit report from Experian. Once you've got the scoop about your credit score, you'll have a better sense of whether paying extra on your car loan is really a good idea.