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Paying Principal on a Car Loan: What Does This Mean?

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When it’s time to get a car loan, you’ll want to have a solid understanding of the difference between what it means to pay principal on a car loan, versus what it means to pay interest fees. Understanding the various parts of your loan could help you make money-saving choices.

What is the loan principal?

There are several moving parts in a car loan. The lump sum of money you borrow to pay for the vehicle (and, sometimes, its taxes and fees) is the principal. You’ll also pay interest, which is what it costs to borrow the principal. The structure of auto loans varies depending on your lender: In general, part of each monthly payment goes toward both the interest and the principal.

When you ask a lender for money to buy a car, it evaluates your financial situation to make sure you can afford monthly payments that include the price of the car plus interest charges.

There are a couple of ways to reduce your loan principal. You could make a down payment or pay your taxes, title and license (TT&L) and dealer fees out of pocket, instead of rolling them into your loan. Reducing the principal means borrowing less, and the less you borrow, the less you’ll pay in interest fees, too.

Paying down principal vs. paying down interest

Most traditional car loans have a fixed payment schedule typically spread out over five to six years. During the earliest months of your loan, a large portion of your payment goes toward paying what’s known as simple interest. This portion decreases over the life of the loan. By the end, almost all of your payment goes toward paying principal.

For example, imagine you had a $500 car payment for 60 months at 2.5% interest.

  • First payment: $441 goes to the principal and $59 goes to the interest
  • Last payment: $499 goes to the principal and $1 goes to the interest

If you make extra, principal-only payments, you can shorten the length of the loan while decreasing the total amount of interest you’ll pay over the life of the loan. Using the example above, if you decide to pay $100 more every month to the principal, you’ll shorten your loan by 10 months and pay $321 less in interest charges. You can play with the numbers for your own auto loan using LendingTree’s car affordability calculator.

How to make principal-only payments

Paying off a car loan early can be beneficial. However, not all lenders allow principal-only payments, so make sure to confirm with yours whether this is an option. Doing so reduces the amount of money they make on your loan.

Once you’ve confirmed with your lender that they’ll apply amounts in excess of your regular monthly payment to the principal of the loan, you can either make larger-than-usual payments or send extra money when your budget allows.

Here are a couple of tips for how to do this:

  • Make a car payment every other week instead of once a month. By dividing your usual monthly car payment in half, you’ll pay the equivalent of one extra payment every year, which will reduce your principal and the total amount of interest you’ll pay.
  • Round up your payment. If your normal car payment is $329, round it up to $400. If you’re having trouble coming up with the extra cash, it may be possible to earn additional income and/or reduce expenses using these hacks.

Paying down the principal vs. refinancing

Instead of making principal-only payments on your existing loan, there are times when replacing it might make better financial sense. Refinancing your auto loan may be a good idea when:

You’re ready for a loan with a shorter term.

You may pay less total interest that way. As an example, if your loan payoff amount is $39,000 at 3.99% interest and you’ve been making monthly payments of $702 for about a year, you could decide you want to refinance to a 36-month term instead of finishing out your original 72-month term. This could save as much as $2,088 over the life of the loan. And while refinancing in this situation brings your monthly payments up to $1,151, you’ll be free from the burden of a monthly car payment about two years earlier.

You can obtain a lower interest rate.

Perhaps your credit score has improved since taking out your original auto loan. For example, if you took out a $20,000, 60-month car loan at 5.9% interest and you’ve made 12 monthly payments of $386 per month, you may be able to refinance at a lower interest rate. If you get a refinanced loan with a 1.99% interest rate, your new payment will be $357 per month for 48 months, and you’ll save about $1,392 in finance charges over the life of the loan.

Which strategy is right for you?

Some lenders won’t let you pay down the principal, so refinancing to a loan with better terms may be the only way to pay off the car loan early. You could use our auto refinance calculator to see if refinancing is right for you.

Before you make a decision, it’s important to understand whether you’ll be charged a prepayment penalty. It doesn’t make sense to pay off a loan early if doing so will cost you more. But if you’re able to land a competitive term and interest rate on an auto refinance loan, you may be able to offset any fees imposed by your previous lender and save money.

If you have a simple interest auto loan without prepayment penalties and your lender will let you pay down the principal, it may make sense to stick with your current loan and work toward paying it off early.

 

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