Paying ahead vs. paying down principal on loan


Dear Steve,
I started with a 72-month, $23,468 auto loan in March 2003. I've paid $400 every month to the present date, although the required payment is only $325 a month. I just found out that the extra money is not going to principal, but it adds time until my next payment is due, which the bank says is in August 2005. How will this help me if I want to trade vehicles in two years? By then the bank will say that I have 10 to 11 months of no payment, due to the fact that I'm so far prepaid. Can this benefit me when I want to trade in and how does that play into the financing of another vehicle at that point? Advice needed. Thank you.
-- Nate

Dear Nate,
A 72-month car loan is a long one. You seem to have thought things out to a point by making sure you could afford lower payments over a longer period of time. It may be, however, that your lender thought about it longer than you did and locked in a long stream of interest payments to offset your thinking.

From what you have said, you have not reduced the principal amount owed on the loan

even though you are paying more than the agreed-upon payment. The upshot of your efforts is that you could skip a year's worth of payments and your lender would not care, because he is still making the money he expected to on this loan. What we have here is a failure to communicate!

When you pay more than is owed on a loan, it is always best to communicate to the lender that you want the additional payment amount to be applied toward the principal in order to save money on the interest. For those of you who are particularly fastidious, I suggest you send in two checks, one for the regular payment and the other for the extra, clearly marked that it is to be applied to principal. This can clarify your wishes beyond a doubt. Please note, however, that your loan may have a prepayment clause that prevents you from being able to reduce the interest paid. You will have to examine your loan documents to determine if that is the case.

If there is no prepayment clause, ask the lender to recalculate your payments thus far to apply the additional $75 per month to the principal and put you back on the same payment schedule. The lender may not choose to do this, as it will cost money, but you can certainly redirect in writing that future payments be handled that way (again assuming no prepayment clause in your original contract).

Nevertheless, when the time comes to trade your vehicle in and finance another one, your timely overpayments should certainly help you. You will have paid nearly a year longer on the vehicle and the bottom line on your loan will be less than anticipated.

As you look for your new car, be sure to read all of the fine print about prepayment options. Also, consider a shorter loan period. The $75 leeway you have afforded yourself was smart thinking, but it exposed you to carrying an upside-down debt for a very long time. By reducing, but not eliminating, the $75 margin of cushion and shortening the term of the loan, perhaps to 48 months, you keep from being upside down in your loan for a shorter period of time. This means you won't owe more on your vehicle than it is worth, which often happens with longer auto loans.

Keep up the good work and good luck!