Carrying debt is always a drain on the finances, so many people look to pay off their loans early. When you’re talking about credit cards or other high-interest revolving debt this is certainly true. But when you’re talking about a lower interest installment loan the benefits may be far less than you anticipated.
The reason has to do with how interest is calculated and applied to different types of debt. With a credit card, interest is calculated on the average balance and applied monthly. So as long as you carry a balance you’ll be paying the same percentage of that as interest from month to month. But when you look at an installment loan or other secured loans like on a home or a car, typically the interest is calculated differently. In these types of loans the interest front-loaded and based off an amortization schedule.
What this means is that in the early part of the loan term a much larger percentage of your monthly payment is being applied to interest than at the later part of your loan. To get an idea of how this works go ahead and pull up this auto loan calculator. If you view the report of the preset data you’ll get a monthly breakdown of payments.
As you can see, in the first year, nearly 30 percent of your payment is going towards interest. In the last year of the loan it’s a mere two to six percent on average. So in reality, during the first few years of the loan you may very well pay thousands of dollars in interest each year, but in the last year or two you’re likely only paying a couple of hundred dollars in interest.
So you really have to look at where you are in your loan to determine whether paying it off early results in the savings you’re looking for. Typically, the closer you are to the end of your loan the less benefit there will be to paying it off early because almost your entire monthly payment is now being applied to the principal. So, run through the calculator with your loan terms and see for yourself how much money you’d actually save and then decide if it’s worth paying the loan off early.
Also keep in mind that your auto loan, mortgage, or other installment loan may have a significantly lower interest rate than other debts you carry. With rates possibly as low as 2 to 5 percent, ask yourself if it’s really worth saving what could be just a couple hundred dollars by paying it off early when you’re carrying other debts with much higher interest rates and costing you more. Sure, it’s nice to enjoy the feeling of having one less monthly payment, but if the math doesn’t work, the math doesn’t work.
Finally, consider the situation of having a bird in the hand or two in the bush. Especially if you are deep into your loan and have already paid the bulk of the interest, does it really make sense to use a bunch of available cash to pay it off early when that money could be used elsewhere why you enjoy the remaining low monthly payments? Run the numbers and don’t be penny wise and pound foolish.
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.