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Paying the Principal on a Car Loan: What Does This Mean?
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Paying more on your car loan seems like the opposite of a good idea. But it’s like getting up early to hit the gym — you’ll thank yourself later when the results start to show.
As you work to get into financial shape, one of the best exercises is to pay extra on the principal on your car loan. Each car loan payment is a mix of interest and principal. The loan agreement for your car should spell out how much interest you’ll pay over the loan term.
While you shouldn’t pay less than what you agreed to for the loan, it’s OK to pay more. It’s for your own good, like that 5 a.m. run. The faster you pay the principal down, the less interest you’ll pay over the life of your loan. You will own your car outright sooner, and you’ll keep more money in your bank account.
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What is the loan principal?
The loan principal is the amount you borrowed to buy the car. Wrapped up in that number are the price of the car, any dealer fees and tax, title and licensing (TTL) fees you might have financed. You can lower the loan principal when you purchase a car by:
Putting more money down
Paying TTL fees up front
Offering a trade-in
Taking advantage of dealer or manufacturer incentives, or
Buying a less expensive car.
The principal is only one part of your payment. The other part is the annual percentage rate or APR. This is the interest rate and other fees incurred for borrowing the money. Your car payment will be a mix of the principal and interest.
During the early part of the loan term, you will pay more interest than principal. Over time, more of the payment goes to pay the principal. The last few payments will be mostly principal with little interest left.
The Truth in Lending disclosure on your loan documents will disclose how much principal and interest you are obligated to pay over the life of the loan.
Paying down principal vs. paying down interest
Most car loans are simple interest loans, which means the amount of interest is based on the loan’s principal balance. The payment is fixed over the life of the loan. But the amount of money that goes to pay the principal and interest will change each month. The interest is calculated each month, so if you pay the principal faster than the loan agreement, the amount of interest will drop as well.
Your financing company may have provided an amortization schedule, which breaks down the amount of principal and interest for each payment. Use the amortization schedule or LendingTree’s car affordability calculator to see how much interest you could save.
For example, if you have a $745.72 payment for 60 months at 4.5% interest, here’s what your first and last payments would look like:
- First payment: $150 goes to interest and $595.72 to principal.
- Last payment: $2.79 goes to interest and $742.92 goes to principal.
When you’re paying extra toward the principal, you will pay off the car loan early and pay less interest. It’s most effective if you can pay down the principal early in the loan term because the interest is calculated on the principal balance.
Ask your lender how they will handle extra payments. Some lenders will apply them to the next payment unless you specifically request to pay down the principal. In that case, you might owe less on the next month’s payment, but may or may not pay down the principal faster. Some lenders have special procedures for principal-only payments.
If you have a precomputed interest loan, the interest is calculated at the beginning of the loan. It won’t change if you pay any additional principal. Make sure you know which type of loan you have before you start making extra payments.
Why pay extra toward the principal?
The biggest reason to pay extra on your car loan is simple: You can save money. By putting extra money toward the principal, you’ll save money on interest over the life of the loan.
You might want to pay off your car loan faster if you want to sell it or trade it in so you build equity in the car. Or, you can free up funds for something else. But if you have a low incentive APR like 0% or 0.9% financing, paying more on the principal wouldn’t make much financial sense.
How to make principal-only payments
Before making extra payments, ask your lender about their procedures for principal-only payments. Some lenders have specific procedures or payment portals for extra principal payments. Of course, your account must be current. If you’re behind on your payments, any extra payment will go toward bringing the account up to date.
If you want to pay off your car loan faster, there are several strategies for applying extra money:
- Lump-Sum: Pay off the entire balance or a large portion of it, at one time. If you have scored a bonus at work or come into unexpected money, this is a great way to knock out the loan. Check with your lender for the final payoff amount.
- Bi-Monthly: Make your scheduled payment and then pay an extra half-payment or more every two weeks.
- Round Up: Round your payment up to the nearest attainable amount. For example, if your payment is $365.82, consider bumping it up to $400 or $450. These small overages will chip away at the principal balance.
- Extra Payments: Make one additional payment a year or at least once during the loan. Every little bit counts.
- Fool the Schedule: If your loan is 72 months, use an auto loan calculator to figure out what the payment would be on a 60-month loan. You’ll have the lower payment of the 72-month loan as a safety net, so if you don’t have the money for the extra payment one month, you can make the lower payment of your 72-month loan and still stay current.
If you can consistently pay as if you had a 60-month payment, you’ll pay off your loan a year early. For example, a $40,000 loan at 5% for 72 months is a $644 month payment. If you calculate the same loan for 60 months, it’s a $755 payment, but you’ll save $1,091 in total interest.
Paying down the principal vs. refinancing
There are times when refinancing your auto loan might make better financial sense than making principal-only payments. Refinancing your auto loan may be the right option when:
You want a loan with a shorter term
You can save interest with a shorter loan term. Your monthly payment will be higher, but you’ll pay less interest overall. Your car will be paid off faster as well.
You can secure a lower interest rate
If your credit score has improved since you took out the original auto loan, you may qualify for a lower APR. If you had a 60-month loan, you could refinance for a 48-month loan at the lower interest rate.
Which strategy is right for you?
Some lenders don’t allow you to pay down the principal, so refinancing to a loan with better terms may be the only way to pay off the car loan ahead of schedule. Use an auto refinance calculator to see if refinancing will accomplish your goals.
Before you decide, check with your lender or review your loan documents to see if you will be charged a prepayment penalty. If that is the case, it may not make sense to pay off the loan early. But if you can land an auto refinance loan with competitive terms and interest rate, it may be enough to cover a prepayment penalty and still save money.
If you have a simple interest loan without prepayment penalties and the lender will let you pay down the principal, it may make sense to keep your current loan and work toward paying it off early.
Frequently asked questions
The lender could have a prepayment penalty that will eat into your savings. Paying off a loan early could impact your credit score, since any major change to your credit history can drop your score slightly. Also, you might prefer to keep your extra cash in hand for other uses, especially if your loan has a low APR.
It is better to pay the principal so you can reduce the amount of interest you pay in a simple interest car loan.
Unless you refinance, large principal payments will not reduce your monthly payments. Check with your lender to see if extra payments are credited against the next month’s payment or go toward reducing the principal. If you make extra principal payments but keep the loan until the end of the term, your final payment may be smaller.