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Ask Dr. Don

Prepaying my auto loan

Dear Dr. Don,
Please help. How will an extra monthly payment of $75 to $100 impact an auto loan of $25,000 at 6.5 percent over five years? Is it worth making extra payments on an auto loan?
Thank you,
Wayne Worthwhile

Dear Wayne,
Review your loan agreement to make sure that your auto loan doesn't have a prepayment penalty. You should also check to make sure that the lender isn't using the Rule of 78s to determine the interest component of your monthly payment because that can affect you like a prepayment penalty. Your auto loan is for 60 months, so you need to check your loan agreement to see how interest is computed on your loan.

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Bankrate's Auto Loan Calculator makes it easy to see how principal prepayments speed up the repayment of your loan. I used that calculator and your information to come up with the table below:

  No prepayments $75 a month prepayment $100 a month prepayment
Loan amount:
Loan term (months):
Interest rate:
Monthly payment:
Total payments:
Total interest:
Note: The last monthly payment for the prepayment options differs from the monthly payment stated in the table.

While it's clear that with no prepayment penalties you can save interest expense by prepaying the loan, the decision to do so is not as clear-cut. What if that $75 to $100 a month would have gone instead toward funding an IRA account or 401(k) plan? You would lose the interest savings but gain the investment returns on the account, plus the potential reduction in income taxes.

It's only a potential reduction in taxes because not every taxpayer qualifies to make tax-deductible contributions to an IRA account, and your employer may not offer a 401(k) or other tax-deferred retirement savings plan. On the other hand, if your employer would have matched all or part of that contribution, then you're giving up even more in retirement savings.

Conversely, by prepaying the loan you free up the $489.15 in monthly payments for the last nine to 11 months of the loan. That money also could go toward funding retirement or other financial goals.

If you've got enough slack in your monthly budget to make additional principal payments on your car without dipping into your emergency fund or shortchanging your investing program for longer-term goals, then these additional payments make sense. Otherwise, keep making the monthly payments.

-- Posted: June 19, 2002

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