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Ask Dr. Don
By
Don
Taylor,
Ph.D.,
CFA
•
Bankrate.com |
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.
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: |
$25,000
|
$25,000
|
$25,000
|
| Loan term (months): |
60
|
51
|
49
|
| Interest rate: |
6.50%
|
6.50%
|
6.50%
|
| Monthly payment: |
$489.15
|
$564.15
|
$589.15
|
| |
|
|
|
| Total payments: |
$29,349.22
|
$28,665.39
|
$28,483.79
|
| Total interest: |
$4,349.22
|
$3,665.39
|
$3,483.79
|
| Savings: |
|
$683.84
|
$865.43
|
| 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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