Is it wise to repay a car loan or home loan early?
If you have the chance to pay down a loan faster, or if you can clear the balance completely, your initial reaction may be to jump at it, but it’s not always as simple as that. Of course, if the debt is high–interest, like a credit card balance, then you probably should relieve yourself of some or all of it.
When it comes to car and home loans, however, it’s not that simple, so if you’re wondering whether to plough more of your disposable income into these debts then you should stop and think first.
Home and car loans are a bit different to other debts
Car loans and mortgages have significantly lower interest rates than, say, a credit card. It’s important for you and the lender that you find the repayments manageable as you’ll be making them for many years. There’s no one best home loan bank or provider, though; it’s a case of comparing the market offerings to find the best one for you.
On the other hand, a debt is still a debt and if you can free yourself up significantly earlier, then you should. There are, however, considerations to be made about paying off a home or car loan early as you might be better off paying one rather than the other.
How do loans work?
Most loans work in the same way. Your monthly car loan repayments, for example, are calculated by working out how much the final value of the loan is, using your interest rate and how many months you’ll be paying for.
Loans also use a process called amortisation, which means that your first payments are mostly of interest and a small amount of capital. As the capital decreases each month, less interest is generated and because you’re still making the same monthly payment, you’re paying down more capital as time goes by.
By making extra payments you can speed up the amortisation process so that you’re removing more of those interest–generating dollars before their time. That is, you pay less interest over the life of the loan.
Should your mortgage be your first target?
You might look at your home loan and think that this should get the treatment; it may well be so, but do the maths first.
The average first-time mortgage in Australia is $384,700 and if you look at a comparison site, you’ll see the average interest rate is roughly 3.5 per cent. In addition to this, most mortgage terms are 25 years.
Entered into a home loan calculator, this all works out as $1,927 each month. That’s $1,927 a month for 25 years, which is $561,601 in total! If, however, you decide to make an overpayment of $50 each month for the whole term, you’ll pay your mortgage off 11 months earlier and save $8,560 in interest.
What about the car loan?
A car loan is probably your next biggest purchase after your home. If you buy a 2018 hybrid car for $29,000 and you have a $5,000 deposit, you’ll need a $24,000 loan. If you compare car loans, you’ll see that the average interest rate is six per cent so if you choose a six–year term you’ll pay $398 a month. This is a total spend of $28,656 as you’ll pay $4,656 in interest.
If, however, you spend that $50 on overpaying your car loan rather than your mortgage, you’ll save $629 in interest and have cleared the loan nine months earlier. Head to a car loan repayment calculator and do the maths.
You’ll save more on the mortgage, but…
You won’t really feel the benefit for 24 years, when you make your final payment. In fact, you’ll be paying slightly over the odds. Every month. For 24 years…
There is of course the argument that you’ll own more of the property so you’ll have a greater equity share when it’s time to sell. This is an attractive argument, but there’s still a long time to wait, whereas you’ll completely own your car in just over five years.
Paying off the debt with the shortest term and highest interest rate (the car loan) might work better for you if you have other debts, as you could use that extra $450 a month plus the $629 to pay something else off.
Paying off your car loan early means you can snowball
The snowball method is a really satisfying and effective way to tackle your other debts.
You pay off the debt with the smallest balance first; it doesn’t matter what the interest rate is, you simply get rid of it.
This leaves you with some extra money each month, so this money goes to the second biggest debt, again, regardless of the interest rate. Then once the second debt is conquered, you go onto the third biggest and so on. Each time you pay off a debt, you have more spare money to throw at your remaining debts. You don’t have to pay any more than you would have done each month anyway, you simply pay your debts off faster.
Ideally you should start your snowball campaign as soon as possible, which points towards paying off the car loan early rather than the mortgage.
Once you’ve freed up that magical $450, you can direct it to whichever debt you like. If you have a few, then the snowball method is ideal, because once they’re paid, as long as you keep hold of your car for another few years, you can make some mortgage overpayments if you want.
There is another mortgage overpayment argument…
You could aim for the asset that’s depreciating at the slowest rate, or, depending on the property market, appreciating the most.
By the time your fancy hybrid is eight or nine years old, you’ll probably get $6,000 for it. You’ve spent quite a lot of money on it, but vehicles depreciate rapidly, especially in the first two years (which is why it’s wise to keep hold of one as long as possible).
Your property, on the other hand, should hopefully sell for at least the same price, if not more. Plus, you’ll have been paying the mortgage for several years, so at sale you’ll have more equity plus profit. If you’re looking further into the future—maybe to retirement or downsizing time—then finding the best home loan rates and overpaying the mortgage is the way forward for you.