You borrowed to finance a purchase of car and now you are dying to pay off the loan as early as possible. Why not? It might just sound very attractive to get done with the loan earlier than it is actually scheduled for, but there are various potential constraints to this situation.
The first question you should ask yourself is that why is your lender making a loan to you in the first place? The answer to this will help clarify the hazy picture: Your lender wants to earn interest. But will it practically leave him at advantage if the loan is paid by you earlier than he had scheduled for you. Well, it will just do the opposite.
An interest is equivalent to your lender’s periodic income. The longer the term of loan repayment, the better your lender will benefit from it because in this case he will earn interest for a longer period of time. If, however, you pay off your debt earlier than the actual schedule, all this will do is to deprive your lender of his later periods’ interest earnings.
‘Time Value of Money’: An Important Concept
For this situation, what you must comprehend is the concept of Time Value of Money. The fundamental assertion of this concept is that the value of a dollar today is not be equal to the value of a dollar in future periods, primarily because of the effects of inflation. The pattern of your loan repayments may act as a tool to aid the understanding of this concept.
Usually what you get is a bunch of low payments in the initial months and relatively higher payments in the future months. This pattern of loan repayments is fixed by your lender because he wants more amount of money to float in during the later months to counter the effects of inflation. But if you decide to pay off your debt quickly, won’t this simply disturb the balance?
Your Lender Versus You:
It is fairly understood that in order to secure a safe deal for himself, your lender will take some precautionary steps to remedy the situation (in which you decide to pay off your debt early). In most cases, lenders will impose and charge a penalty fee from you in case you pay off early.
Therefore if you are attempting to go for early payments, you may end up paying more! One thing should be clear here that we are not talking about any lump-sump payments of loan. The rationale is fairly simple here. A person with the ability to make a lump-sum repayment should be able to buy his car without any financing at all.
Your Solution:
If your want to pay off your loan early at all costs, there may be other solutions to resort to. The best way you can avoid early payment penalties is by depositing all your loan repayments in a ‘Defeasance Account’. This is one such account from where your money will be periodically transferred to your lender’s account, as per your repayment schedule.
This would ensure a continuous inflow of interest money to your lender, just as he anticipated, and this will certainly establish an improved credit standing for you too.
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