Paying off auto loans early may not make you money ahead

The four-year auto loan was about halfway through the third year of payments when the car's owner called the bank. He wanted to pay off the loan early and wondered about sending in more money each month, perhaps making double-size payments.

That could be done, the bank officer told him, but it wouldn't make much sense financially; most of the money sent in those first two years was interest and the rest of the debt represented principal on the loan. Thus, at this point the total amount of money paid would be the same.

The auto owner had just learned a lesson about borrowing: While it seems to make sense to prepay a loan, it often saves the borrower no money and may be more costly in the long run. And you should shop around for loans and check the terms carefully before signing the dotted line.

When interest rates are as high as they have been for the past few years, the temptation to get out from under loans based on these rates is strong, particularly when rates on new loans are moving down. But in most cases, financial advisers say, you should avoid this temptation.

Banks and other lenders have a variety of ways to discourage early payments. After all, their long-range plans are based in part on expected income from outstanding loans, which are listed as ''assets'' on their financial statements.

One of the most common ways banks have of keeping these loans active is based on something called the ''Rule of 78s.'' This is not actually a prepayment penalty, says Thomas McFarland, president of the New England Financial Planning Group in Burlington, Mass. Instead, Mr. McFarland notes, the rule creates a ''front-end load,'' with nearly all the early payments representing interest. This is the situation our car buyer found himself in.

The Rule of 78s is also sometimes called the ''sum of the digits,'' because the sum of the digits 1 through 12, for a 12-month loan period, add up to 78. A loan that uses this concept does result in equal monthly payments, but as we have seen, it has an important disadvantage if you want to pay it off early.

Some lenders have a more direct approach. They simply use a loan agreement that says you ''may'' or ''will not'' have to pay a penalty if you pay off the loan early. If ''may'' is checked, the loan agreement should spell out just want the penalty is and when it will be used. Some states have prohibited prepayment penalties altogether. A consumer affairs office could tell you if your state is one of these, if the banker hasn't already done so.

Because there is so much competition among lending insitututions in this deregulating age, more banks are using neither the Rule of 78s nor prepayment penalties. ''We have no prepayment penalty on consumer loans, just simple interest,'' said Christine Scarpetti, a lending officer and director of consumer education at the Boston Five Cents Savings Bank. Here, payments are calculated each month on the basis of outstanding principal. So if you make some early prinicpal payments, your subsequent payments will be lower.

''More and more banks are going to simple interest,'' Miss Scarpetti says. ''We're seeing the Rule of 78s being used less often.''

Finding a bank that uses simple interest should not be that hard, says Grace W. Weinstein, author of ''The Lifetime Book of Money Management'' (New American Library, New York, $19.50). ''Particularly now with heightened competition, this situation has improved,'' she said. ''So it definitely pays to shop around.'' She suggests asking each prospective lender how much he would owe if he paid off the loan at a specific date before maturity.

If you do find yourself with some extra money, there are better things to do with it than making early loan payments, contends Flora Williams, professor of consumer sciences and retailing at Purdue University. She suggests investing the extra money, perhaps in a money-market fund. She says people in the 30 -percent-or-higher tax bracket may want to invest in a tax-free fund, since they can deduct the interest on outstanding loans while getting a good return on their tax-free investments.

An IRA and a Keogh?

During the first half of this year, I received wages as an employee of a large company. During that time, I deposited $2,000 in an individual retirement account (IRA). During the second half of this year, I have been self-employed as an independent contractor for my services.

In addition to the IRA (to which I have already made the maximum allowable contribution), can I also open a Keogh account for this year, to which I could contribute 15 percent of my self-employment income? - D. B. Yes, you can. A Keogh can be used for any self-employment income, no matter when it is earned. Contributions to an IRA, on the other hand, must come from wages or salary earned from an employer. You could, in fact, have opened a Keogh while you were working for that employer if you had been doing some outside or free-lance work. Money from your wages would go into the IRA while the free-lance money went into the Keogh.

If you would like a question considered for publication in this column, please send it to Moneywise, The Christian Science Monitor, One Norway Street, Boston, Mass. 02115. No personal replies can be given by mail or phone. References to investments are not an endorsement or recommendation by this newspaper.

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