According to the National Automobile Dealers Association, as of September of 2010, the average new car costs $29,428 and the average used car costs $16,321. Either of these two prices represent an investment larger than the vast majority of American households are willing or able to make as a one-time purchase. Because of this, most car buyers choose to borrow money when they buy or lease a vehicle.
How Financing Works
Financing works on a very simple principle: the lender agrees to give the borrower a lump sum of money up front in exchange for the borrower's promise to pay the money back over time. Lenders charge an interest rate, which is computed as a percentage of the amount of the loan, which compensates them for the use of their money. Typically speaking, the longer that a loan is extant, the more interest that the buyer will pay. Making additional payments typically has the effect of shortening the loan, which reduces the amount of interest that will be paid.
Simple Interest vs. Rule of 78
Most car loans are calculated on the basis of "simple interest." This means that every month's payment includes that month's interest on the total amount due and an additional sum applied to the principal of the loan. Rule of 78 or "pre-computed interest" loans are set up in which the borrower pays all of the interest up front, then pays the principal. With these relatively rare loans, since the interest is prepaid, paying them off early by making extra payments will result in no savings.
Understanding the Cost of a Loan
A $28,000 simple interest car loan with a five-year term and a typical interest rate of 7 percent carries a monthly payment of $554.43. This payment consists of $163.33 in interest, which represents 1/12th of 7 percent of the loan's balance, and then a payment of $391.10 in principal. In the next month, because the loan balance is almost $400 less, the interest payment is also less, allowing the borrower to pay back a little bit more principal. This continues until the final payment on the loan which consists of $551.22 of principal and $3.22 of interest. Over the five-year period, this loan would cost a total of $5,266.01 in interest.
Making Extra Payments
The amount that you would save by making extra payments varies depending on how much extra you pay and how often you do it. Taking the loan above as an example, if you were to make an extra payment every five months, it would roughly be the equivalent of paying off the loan in four years. This would save approximately $1,082.00 in interest. Another example would be paying $600 per month instead of $551.22, which is the rough equivalent of making one extra payment out of every 10. Doing this would pay the loan off in five years and seven months and result in saving $486.53 in interest.
Low/No Interest Car Loans
If you have a car loan with little or no interest, such as the promotional loans with 0 percent APR or 1.9 percent APR, paying the loan off early is usually a poor idea. The reason for this is that your money may be making more in the bank than you are paying in interest. Using savings that are in a money market account paying you 1 percent to pay off a car loan that costs you 8 percent is a wise thing to do. Pulling money out of a certificate of deposit account that is paying you 2 percent to pay off an interest-free car loan, though, will cost you money.
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