Should You Pay Off Your Car Loan In A Lump Sum Or In Smaller Repayments?
Coming in to a little chunk of cash is a position many of us would like to find ourselves in.
Whether you got a bonus at work, a nice little birthday present, or have received an inheritance, there are plenty of things you could spend your extra money on.
You could put it towards a vacation, go on a shopping spree, or buy that new cell phone you’ve had your eye on. You might even have that little voice of reason in your head that says maybe you should put it towards your credit card or car loan.
So should you pay off your car loan in a lump sum?
There are a variety of things to consider when looking at paying off your car loan in a lump sum as opposed to regular monthly repayments. Read on below to see some of the key benefits and downsides.
Benefits Of Lump Sum Repayments
Obviously, putting any amount of money towards your debts will generally be a good thing. No one likes having loans over their heads, so many people would think that clearing it as fast as possible would be the ideal solution. Some benefits of putting your bonus towards paying off your car loan include:
Lower Your Interest Repayments
If your bonus doesn’t clear your loan completely, you will at least make a significant dent in the amount of interest you are paying in each subsequent repayment.
Depending on the interest rate you have on your car loan, a large proportion of your monthly repayments could be taken up by interest. This essentially equates to the amount of money the lender is making in profit when they lend you the money. The other part of your monthly repayments would be made up of equity in your vehicle, which will eventually reach 100% and the car will be yours.
By putting a large amount towards your car loan, every monthly repayment that comes after it will have less interest applied to it. That’s because the interest charge is directly proportional to how much money you have left owing the lender. By paying back a large piece of the loan amount, the interest applied will be lower, thus saving you money in the long run.
Shorten Loan Repayment Term
Another benefit of putting your extra cash towards your car loan is that you will inevitably shorten the length of the loan term.
Your loan term is the amount of time it would take you to pay off your loan. This is usually determined at the beginning of a loan agreement, and your interest rate will often be directly proportional to the amount of time you choose to pay off the loan in. Common loan terms are anywhere from 12 months to 30 years, depending on the type of loan and the amount borrowed.
Putting your bonus towards paying off your loan can shorten the amount of time you will need to pay off your loan. This means that you can stop making monthly repayments sooner and put that extra money towards something else. Care should be taken if choosing this option, however, as lenders have built in several clauses to loans that can make early exits costly.
A less measurable but no less beneficial aspect of using your bonus to pay down your car loan is the psychological boost you will receive in seeing your debts disappear.
Having credit card balances and car loans appear on your banking statements every month can be mentally and emotionally exhausting. If you are struggling to keep up with repayments and feel like you’re making no progress towards clearing them, using your extra cash to clear some of those debts can be just the pick-me-up you need.
When you use a large sum of money to clear debts, you won’t have to deal with those monthly repayments anymore, and not having the weight of debt over you can give you a whole new lease on life. This aspect in and of itself could be reason enough to part ways with your bonus and put it towards your balances. Your psyche and those of your loved ones could thank you.
Downsides Of Lump Sum Repayments
While there are certainly several upsides to putting your money towards paying off your loans sooner, there are some unexpected negative aspects about early repayments. These may not apply to every loan or situation, but they are things you should be mindful of before you hit ‘send’ on those payments.
Potential Early Exit Fees
As mentioned above, one of the ways that lenders protect their profits from loans is establishing early exit fees.
These fees are applied when a loan is paid off faster than the agreed upon loan term. Unlike with mortgages, where the Canadian government allows borrowers to submit early payments without penalty, personal loans are not subjected to these laws. This means that it is up to the lender to determine whether they wish to charge early exit fees. Many lenders do apply these fees, as when you pay off a loan sooner than expected, the lender is actually losing money through lost interest repayments.
Exit fees vary greatly in their cost and in which circumstances they are applied. Ensure you look into what fees you might have to pay if you put your bonus towards your car loan. If it ends up costing you more than what the interest portion of your repayments would be for the rest of your loan, it makes more sense to stick with a regular repayment plan.
Loss Of Safety Net
Receiving an unexpected pile of cash is also a great opportunity to create a safety net for yourself, but if you put your bonus towards your loans, you will lose that.
Most financial advisors recommend having a safety net emergency fund you can access in the event of an expensive emergency, such as car repairs, loss of employment, medical issues, and so on. Having this extra money set aside for a rainy day can give you peace of mind knowing you can handle whatever life throws at you, and gives you one less thing to worry about in the event of an emergency.
Using up all your windfall money to clear your debts can be very tempting and can be the right decision for many people, but be careful about being left with no emergency funds. Should you end up needing to max your credit cards and take out more loans to cover an unexpected situation, you could actually end up with more debt and a worse credit score in the long run.
Potential Opportunity Cost
Something that is less tangible but no less important is the potential opportunity cost of using your extra money to clear your debts.
Opportunity cost is the loss of potential gain from other options than the one you have chosen to pursue. For example, you could use your bonus to clear your debts, but than you would not be able to invest that money in the stock market and earn dividends from your investment. Similarly, you would not be able to keep it in savings and earn interest or put it towards your retirement. There is even the opportunity cost of not going on a holiday with the extra money, as your enjoyment can count as a lost “potential gain” in this scenario.
This is often one of the elements of any decision many people struggle with; the “what if” side of decision making. If clearing your debts would bring you the greatest potential gain in terms of your financial and emotional health, then it is the clear winner. However, if you would actually end up making more money through investing your bonus, or if you really need that vacation with your friends, it is worth taking a bit more time to consider your options and deciding what is really important.
Lost Potential Credit History Improvements
Paying off your car loan in one go can also leave extra credit history improvements on the table.
Your credit history is the single largest contributor to your credit score. It is made up of credit inquiries, defaults on loans, and most importantly, your repayment history. Making regular, on time repayments is the best way to improve your credit score, as it shows responsibility with your finances and trustworthiness for potential future credit providers.
By paying off your car loan with one large payment, you are missing out on further regular repayments, which can ultimately leave you with a lower credit score than you might have had if you had stuck to a monthly repayment plan. If you have bad credit and are looking at doing anything you can to improve it, it might be worthwhile setting that extra cash aside and using it every month to pay off your car loan so you can maximise the number of regular, on time repayments you get out of the loan.
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