Car owner will save by paying off 6-year loan

Q I am six months into a 6-year auto loan. Thanks to changes in my personal finances, I now can pay more per month and retire the loan sooner. The payment could be as much as three times more. Is it better to add to the monthly payment? Or save the money to earn interest and then pay off the loan when I have enough savings to pay it off? I know that interest paid on loans typically is higher than interest earned on savings.

Another scenario would be to refinance with a shorter-term loan carrying a higher monthly payment. Shorter-term loans typically have lower rates, so would that be better? Would that provide a lower overall interest on the loan?

LES

AYour question raises an important point about 72-month (6-year) auto loans. I'm not a fan of them. Yes, you get the benefit of a relatively low monthly payment compared with the more traditional two- to three-year car loan. But the overall price tag is much higher. You'll owe more than the car is worth for much of the loan period. It's often a sign that you're buying a too-expensive car. If you borrow to buy a car, I would stick with a two- to three-year loan, and if it turns out the monthly payments are too high, look for a cheaper car.

That said, you want to get rid of the loan on the early side anyway. That's good. My advice on how aggressive to get with the auto loan at the moment essentially depends on the health of your emergency fund. Since your financial circumstances have changed for the better, I would put a priority on building up your financial margin of safety. Taking advantage of your improved income to add to savings becomes even more important if you're at all concerned about job security in our uncertain economy. The best way to stay disciplined with savings is to have a sum of money automatically removed from your checking account every month and deposited into your savings account.

Make sure you also are taking advantage of your retirement savings plan at work or, if your employer doesn't offer one, save for retirement on your own.

It's not worth refinancing your auto loan since you can accelerate payments on your own. I would get aggressive with the auto loan once you've shored up your emergency savings. You can play with the numbers and run various scenarios at auto loan repayment calculators on websites like www.dinkytown.net and www.bankrate.com.

Ask your lender about its procedure for putting additional payments toward reducing principal. You should also feel free to send in larger chunks of money out of savings toward principal, just so long as you don't cut into the savings buffer too much.

One last recommendation: Once you've paid off the car loan, I would maintain the habit of writing the monthly payment check -- not to the lender, but to yourself. You can add the money to the sum that is being automatically transferred from your checking to your savings account.

Oh, and drive the car into the ground.

Chris Farrell is economics editor for "Marketplace Money." His e-mail is cfarrell@mpr.org.

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