Dear Dr. Don,
Is it wise for me to pay off my simple interest car loan early? I want to pay it off, but the company is telling me that my balance is the same whether I pay it now or pay it over the next 17 months. This makes no sense.
-- Jane Jalopy
Thank you for asking the question. To give you a correct answer, it is helpful to explore the type of auto loan you currently have.
My sense is that yours is a simple add-on interest auto loan as opposed to a simple interest loan. An add-on loan adds the interest expense to the amount borrowed and spreads those payments over the loan term. You can't reduce the interest expense by paying off the loan early because the total interest expense is included in the loan balance.
How interest is charged
A simple add-on interest auto loan charges interest as if the initial money borrowed is outstanding for the entire loan period. That effectively doubles your interest expense, because you are paying down the loan proceeds over the life of the loan, making the average money borrowed over the loan term one-half the initial loan amount.
If a simple add-on interest auto loan does allow you to pay off the loan early, there is often a prepayment penalty that reduces the interest savings or the interest rebate is determined using the Rule of 78s, which frontloads the interest expense over the life of the loan.
Check your loan documents
Because the lender is telling you there's no benefit to paying off the loan early, it sounds like your loan isn't structured to provide you with any interest savings by prepaying the loan. Still, it would be worth reviewing your loan documents to confirm that there is no interest rebate if you pay off the loan early. Refinancing won't help because you're already committed to paying the interest expense on the existing loan.
Don't forget our trusty calculators
Bankrate's auto loan calculator calculates the monthly payments on a simple interest loan and shows the amortization of that loan over the loan term. If the lender's numbers don't match Bankrate's, they need to explain why. Odds are it's a method of interest calculation that benefits the lender, not the borrower.
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