How to Pay Off Your Car Loan Early

We often hear and read about the importance of paying off debt such as credit cards, student loans, and mortgages. Lost in the pay-off mania seems to be car loans. Perhaps it is that people have reluctantly accepted that having a car payment is just a fact of life, and therefore pay little attention to paying it off early. But there are compelling reasons why you should consider doing exactly that.

Why Pay Off Your Car Loan Early?

Dollar for dollar, a car loan is just about the most expensive loan type that you have. Relative to the amount of money that you owe on the loan, the payment on a car loan is higher than just about any other loan type.

This is because mortgages and student loan debts are spread out over 10, 20, or 30 years, while credit cards are revolving in nature and are never actually paid off. You can have a $400 per month payment on a $10,000 car loan, while the monthly payment on a similar amount of credit card debt can be less than $200.

But because of this, there is almost no debt that you can pay off that will do more to free up your cash flow than paying off your car loan. The sooner you can, the more money you will have available for everything else – including paying off other debt.

How can you make that happen without breaking your budget?

Add Extra Principal Each Month

One of the easiest ways to do this is simply by adding an extra principal payment each month. This is similar to what you will do in paying off a mortgage, except that with the car loan it will happen much faster because the loan is shorter to begin with.

If you have a $20,000 car loan with a 60-month term, you will have a monthly payment of $368 assuming a 4% rate of interest. But if you add $100 to each payment, you will cut the loan term down to 47 months – a reduction of more than a year.

In order to help you calculate a workable payment, you can use an amortization calculator to run different scenarios. Find a payment you’re comfortable with, stick to it over the balance of the loan, and you’ll have the loan paid off in much less time.

Pay Based on a Shorter Term

Another way to pay off your car loan early is simply make payments based on the short-term. Once again, using the example of the $20,000 car loan with a 60-month term and a $368 per month payment, if you decided you want to pay off the loan in 48 months rather than 60, you simply make the monthly payment based on a shorter loan term.

Again, using an amortization calculator, you can calculate a shorter loan term length. You will find that if you want to pay off the loan in 48 months rather than 60, you can increase your monthly payment from $368 to $452. That will increase your monthly payment by $84, but it will chop an entire year off the loan term.

Apply Any Windfalls to the Loan Balance

Perhaps the easiest way to pay off a car loan early – or any loan for that matter – is to apply any windfalls received to the loan balance. That will accelerate the payment of your loan without disturbing your regular monthly budget.

If for example you decide to apply your income tax refund to the payoff of your car loan each year, you can easily cut the term by a couple of years. Since the average income tax refund is in the neighborhood of $3,000, if you apply this to your loan balance for three years, you can pay off your loan pretty quickly.

And even more important, you’ll not be required to increase your monthly payment – and tighten your budget in the process – in order to make it happen. And while parting with the windfall won’t be entirely pleasant, you’ll have a definite benefit when your car loan is paid off and you own your car free and clear – well ahead of schedule.

Set Up a “Sinking Fund”

If you are not comfortable applying extra principal payments or cash windfalls to your car loan – perhaps out of concern for not having cash available for emergencies – there is a way that you can do this without fully committing the money.

In the business world, it is common to set up a “sinking fund” for the eventual retirement of a debt. Rather than making extra principal payments (or any principal payments at all), the business gradually accumulates money in a separate account dedicated to the payoff of the loan. This enables the business to pay off the loan completely at a predetermined date the future.

You can do the same thing by creating a special account that will hold any money intended to payoff your car loan. Instead of making extra principal payments, or applying windfalls to your car loan, you can instead direct them into the sinking fund account. When the amount of money in the account is sufficient to pay off the loan, you empty the account and pay the loan – in full.

How important do you consider it to be to pay off your car loan early? Leave a comment!

Kevin Mercadante is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry. He lives in Atlanta with his wife and two teenage kids and can be followed on Twitter at @OutOfYourRut.

All posts by Kevin Mercadante