You may not save a huge amount on interest, but you’ll free up cash in your budget every month.
FORTUNE — Let’s say you have an extra few thousand dollars — maybe from a tax refund, a bonus, or some other quick windfall. How can you best put it to use?
There are a lot of options, and high-interest rate debt goes on top of the pile. But if you haven’t done that kind of borrowing, and you have a comfortable cushion of emergency cash, you might consider throwing it toward your auto loan.
Why? Not because you’re going to save a huge amount on interest. You will save some, but most car loans have fairly low interest rates these days, averaging 2.98% for a 60-month new car note. (Note: Used car loans are — surprisingly — even a little cheaper than the new ones. They’re averaging 2.78% on a 48-month loan, 2.86% on a 60. If you had lousy credit or didn’t shop carefully for financing when you bought your car, refinancing is a good and simple move. Credit unions are a particularly good source of loans.)
But the majority of car loans are calculated using what’s called the simple interest method, says Mike Sante, managing editor of Interest.com. This means the interest paid each month is based on the loan’s outstanding balance. “The earlier you pay off or pay down these loans, the more you’ll save in interest payments.” You can figure out how much you’ll save on your particular loan by plugging your numbers into a calculator like the one at Bankrate.com.
Not wowed by the figure? You don’t have to be. The real reason for getting out of a loan like this early is that you’ll be freeing up money in your budget every month. There’s an opportunity cost involved whenever you borrow money, and it’s a cost many people fail to consider.
“We are in favor of paying off auto loans early because it can help you cope with sudden life changes and afford you more freedom in the long run,” says Philip Reed, Edmunds.com senior consumer advice editor.
This is, by the way, is the same logic that suggests it’s a good idea to get out of your mortgage — despite its low rate — before you retire. And that, if you have extra cash to throw against your student loan, you should consider that too. It’s not the hefty interest rates associated with these debts, but rather the fact that you have them that stops you from doing other things.
The average monthly payment on a car loan right now is $471 — what else could you do with that money each month? For instance, if you invest it instead at a 6% interest rate, you’d have close to $77,000 after 10 years. You could build a fully fleshed-out safety net — something more than half of all Americans don’t have right now. Or maybe it would simply give you a little more breathing room in your budget.
In the best of all possible worlds, you could also use that freedom as an opportunity to build a habit of saving. Let’s say you have $3,000 left on your car loan, and you pay it off in one shot with a windfall (very possible, as the average tax refund this year is very close to that number). Then you invested the $471 every month, like the example above that gives you $77,000 after 10 years. If you instead just invested that $3,000 at 6%, you’d only have $5,373 after 10 years. Now, obviously, you’re investing a lot more money with the first example, and that’s why you end up with much more. But part of the reason we don’t save is that we never give ourselves the ability to see how good it feels. Once you start to see your money growing, you’ll be inspired to keep at it.
If you decide to put a chunk of money toward your auto loan, you want to make sure you’re actually paying down principal. In many cases, paying extra will signal to the lender not that you are trying to reduce the amount of interest paid or get out of the loan early, but that you don’t have to make another payment for a few months. If you want the payment to go toward principal — and you do — you should call the lender and ask how to make that happen. “In some cases, you may need to restructure the loan (which can be done without prepayment penalties). In others, you might have to write two separate checks and clearly instruct the second payment to go toward principal,” Reed says.
Arielle O’Shea contributed to this report.
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