How Auto Loans Work and How to Pay Them Off Early

The average new car loan in the US is now over $40,000, with average monthly payments above $730. Used car loans aren’t far behind at around $525 per month. If those numbers make you want to pay off your auto loan faster, you’re thinking clearly. But before you start throwing extra cash at your car payment, it helps to understand exactly how auto loan interest works, because it’s different from credit cards in ways that matter.

How Auto Loan Interest Works

Most auto loans use simple interest, which is calculated based on your remaining balance each day. This is different from credit cards, which typically use compound interest that charges you interest on top of interest.

Here’s how the daily calculation works:

1. Take your annual interest rate and divide by 365 to get your daily rate
2. Multiply your current balance by the daily rate
3. That’s how much interest accrues each day

Example: You have a $25,000 auto loan at 6.5% interest.

• Daily rate: 6.5% / 365 = 0.0178%
• Daily interest: $25,000 x 0.000178 = $4.45 per day

That’s $4.45 every single day in interest charges. Over a month, that’s roughly $134 going to interest alone. As your balance decreases, the daily interest charge decreases too, which means more of each payment goes toward principal over time. This is called amortization.

How your payment gets split

Every monthly payment is divided between interest and principal:

• Early in the loan: A larger portion goes to interest. On a $25,000 loan at 6.5% over 60 months, your first payment of $489 splits roughly $134 to interest and $355 to principal.
• Late in the loan: Most of the payment goes to principal. Your last few payments are almost entirely principal with just a few dollars of interest.

This is why extra payments are most powerful early in the loan. Every dollar of extra principal you pay reduces your balance, which reduces the interest charged on every future payment.

Why Early Payments Save You Real Money

Because auto loans use simple interest, any extra payment goes directly to reducing your principal balance. And a lower balance means less interest accrues every day from that point forward.

Example: On a $25,000 loan at 6.5% for 60 months:

• Normal payoff: You’d pay $4,355 in total interest over 5 years
• Adding $100/month extra: You’d pay off 11 months early and save $1,044 in interest
• Adding $200/month extra: You’d pay off 19 months early and save $1,767 in interest

The earlier you start making extra payments, the more you save. An extra $100 in month 3 saves more interest than an extra $100 in month 48.

Check for prepayment penalties

Before you start making extra payments, confirm your loan doesn’t have a prepayment penalty. Most modern auto loans don’t, but some (particularly from buy-here-pay-here lots or subprime lenders) do. Check your loan agreement or call your lender.

Also verify that your extra payments are being applied to principal, not just advanced toward next month’s payment. Some lenders will apply extra money as an early payment of next month’s bill (interest and all) rather than a principal-only payment. Call your lender and specify that extra payments should go to principal reduction.

Strategies to Pay Off Your Auto Loan Early

Make biweekly payments

Instead of paying $489 once a month, pay $244.50 every two weeks. Because there are 26 biweekly periods in a year, you’ll make the equivalent of 13 monthly payments instead of 12, all without dramatically changing your cash flow.

On a $25,000 loan at 6.5% for 60 months, biweekly payments shave about 5 months off the loan and save roughly $500 in interest.

Round up your payment

If your payment is $489, round up to $500. That extra $11 per month doesn’t feel like much, but over 60 months it adds up. Better yet, round up to $550 or $600 if your budget allows.

Apply windfalls

Tax refunds, bonuses, birthday money, side hustle income. Whenever unexpected money comes in, applying even a portion of it to your auto loan can make a significant dent. A single $1,500 tax refund payment early in a 60-month loan can save you several hundred dollars in interest and shorten your loan by multiple months.

Refinance to a lower rate

If interest rates have dropped since you got your loan, or if your credit score has improved, refinancing can lower your rate and either reduce your monthly payment or shorten your term.

When refinancing makes sense:

• Your current rate is at least 1-2 percentage points higher than available rates
• You have at least 24 months remaining on your loan
• Your car’s value exceeds what you owe (you’re not upside-down)
• Your credit score has improved since the original loan

Watch out for: Extended loan terms that lower your payment but increase total interest paid. If you refinance a $20,000 balance from a 5-year term to a new 5-year term, you’re resetting the clock. Refinance to a shorter term or the same remaining term for the best savings.

Understanding Upside-Down Loans

You’re “upside down” (or “underwater”) on your auto loan when you owe more than the car is worth. This is more common than you’d think, especially in the first couple years of ownership.

How it happens:

• Cars depreciate the moment you drive them off the lot (typically 20% in the first year)
• Long loan terms (72-84 months) mean slower principal paydown
• Rolling negative equity from a previous car into the new loan
• Low or zero down payments

Why it matters:

• If you need to sell the car, you’ll have to pay the difference out of pocket
• If the car is totaled, your insurance pays the car’s current value, not what you owe
• It limits your options if your financial situation changes

What to do about it:

• Make extra payments to build equity faster
• Consider gap insurance if you’re significantly underwater (gap coverage pays the difference between what you owe and what insurance pays if the car is totaled)
• Avoid rolling the negative equity into a new car loan, which just makes the problem worse

Gap Insurance: Do You Need It?

Gap insurance covers the “gap” between what your car is worth and what you owe on it if the car is totaled or stolen. It’s worth considering if:

• You put less than 20% down
• Your loan term is longer than 60 months
• You rolled negative equity from a previous loan
• Your car’s value is depreciating faster than you’re paying down the loan

You can often buy gap insurance from your auto insurer for $20-$40 per year, which is significantly cheaper than buying it from the dealership (where it might cost $500-$700 as a one-time fee added to your loan).

Once you’ve built enough equity that your car is worth more than you owe, you can cancel gap insurance.

The Case for Not Paying Off Your Auto Loan Early

In some situations, it actually makes sense to keep your auto loan and direct extra cash elsewhere:

• Your interest rate is very low (under 4-5%). If you have high-interest credit card debt, extra payments toward the credit cards will save you far more than extra payments on a cheap auto loan.
• You have no emergency fund. A small emergency fund (even $1,000) protects you from going further into debt if something unexpected happens. Build that before accelerating auto loan payments.
• The prepayment penalty exceeds the interest savings. Rare, but check.

The debt avalanche method says to always target your highest interest rate first. If your auto loan is at 4% but your credit cards are at 22%, the credit cards should get your extra dollars until they’re paid off.

Frequently Asked Questions

Does paying off my car loan early hurt my credit score?

It can cause a small, temporary dip because you’re closing an installment account, which may reduce your credit mix. But the effect is typically minor (5-10 points) and recovers quickly. The interest savings from early payoff almost always outweigh any small credit score impact.

Should I refinance or just make extra payments?

If your current rate is significantly above market rates, refinance first to lock in the lower rate, then make extra payments on the refinanced loan. If your rate is already competitive, skip the refinancing hassle and just pay extra directly.

How do I know if my extra payments are going to principal?

Check your loan servicer’s website or app. After making an extra payment, look at your principal balance. If it dropped by the full amount of your extra payment, it was applied to principal. If not, call your lender and ask them to reapply it. Going forward, specify “principal only” when making extra payments.

Is it better to make one large extra payment or many small ones?

With simple interest loans, making payments sooner is always better because interest accrues daily. Paying $50 extra each week reduces your average daily balance more than paying $200 extra once a month. But honestly, the difference is small. The most important thing is consistency, so pick whichever approach you’ll actually stick with.

What happens when I pay off my auto loan?

Your lender will release the lien on your vehicle, and you’ll receive the title (or an electronic lien release, depending on your state). You should also contact your auto insurer to update your policy. Some people choose to reduce coverage once the lender no longer requires comprehensive and collision insurance, though this is a personal risk decision.