Paying Principal on a Car Loan: What Does This Mean?
When it’s time to get a car loan, you’ll want to have a solid understanding of the difference between what you’re paying toward the principal versus what you’re paying in interest fees. Understanding the various parts of your loan could help you make money-saving choices.
What is loan principal?
There are several moving parts in a car loan. The lump sum of money you borrow to pay for a vehicle 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 borrow a car, it evaluates your financial situation to make sure you can make monthly payments that include the price of the car plus interest charges.
When you buy a car, you’ll pay a certain price for the vehicle plus dealer fees, sales tax, licensing, and title fees. The total of those costs is the principal of your car loan if you choose to finance the total amount. You typically would finance all taxes and fees — title, taxes and license (TT&L) fees may be as much as 8% to 10% of the sales price of a new car — if you go through a dealership, but you might not have to do so if you arrange your own financing or buy a car from a private seller.
Paying down principal vs. paying down interest
Before getting a loan, you’ll come to an agreement with the vehicle’s seller on a price. Remember, the principal is the amount of money you agreed to pay back, so read your contract carefully to make sure you know what, if anything, it includes besides price — car dealers love to focus on monthly payment price, but that number can mask hidden fees. You’ll hand this money (or the financer will send it) directly to the dealer or owner of the car you’ve decided to buy.
Monthly payments. In general, your monthly car payments go toward any outstanding late fees, first. Then, your lender will apply some of the payment to outstanding interest due. The remainder of your payment goes toward the loan’s principal.
Most traditional car loans are amortized with a fixed payment schedule. You’ll pay simple interest on the amount of money you borrow. During the earliest months of your loan, more of your payment goes toward interest than principal.
Toward the end of your loan, the majority of your payment goes toward paying principal. If you make extra payments toward the principal, you can shorten the length of the loan while decreasing the total amount of interest you’ll pay over the life of the loan. You may have to specifically request that the lender apply the extra payment toward the principal only. It’s important to understand your loan terms before attempting to make extra payments toward the principal of your loan.
Your lender agrees to let you borrow money from them if you agree to pay the amount you borrowed, plus a pre-determined amount of interest on the loan. The lender may offer you a simple interest loan or a compounded interest loan.
If your loan has simple interest (most auto loans do), it’s calculated on a daily basis on the remaining principal of the loan. The interest does not accrue or add up over the life of the loan. When you pay extra money toward the principal, you reduce the total amount of interest charges.
With a compound interest loan, the borrower pays interest on the principal, plus the accrued interest. This means that the interest balance is always growing.
If the loan terms include pre-computed interest, the lender makes the same amount of money off of your interest payments even if you pay off the loan early. They calculate the total amount of interest based on the original loan amount and it doesn’t change over the life of the loan.
How to pay off your car loan early
Paying off a car loan early can be beneficial. If your lender charges simple interest and they’ll allow you to pay it off sooner than planned, you’ll pay less money toward interest charges; 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 some other tips for paying off your car loan early:
- Make a payment every other week instead of once a month. This means 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. In this scenario, if you borrowed $15,000 at a 2.5% interest rate, you’ll cut eight months of payments off your 4-year loan.
- Refinance the loan. We’ll talk about this in more detail, below.
Paying down the principal vs. refinancing
There might be several reasons why refinancing your auto loan might make financial sense. It means obtaining a new loan to pay off your existing auto loan, hopefully at a better interest rate or with better terms.
It might make to sense to refinance if:
- You decide to get a loan with a shorter term. You may pay less total interest that way. If your loan payoff amount is $39,000 at 3.99% interest and you’ve made 12 monthly payments of $702, but you decide you want to refinance to a 36-month term instead of finishing out your original 72-month term, you’ll save as much as $2,088 over the life of the loan. Refinancing in this situation brings your monthly payments up to $1,151, but you’ll be free from the burden of a monthly car payment 26 months earlier.
- You can obtain a lower interest rate. Perhaps your credit score has changed 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 $385.73 per month, you may be able to refinance with a lower interest rate if your credit score has gone up. If you get a refinanced loan with a 1.99% interest rate, your new payment will be $356.95 per month for 48 months and you’ll save $1,381.12 in finance charges over the life of the loan.
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 pre-payment penalty. It doesn’t make sense to pay off a loan early if doing so will cost you more. In this case, check out your options for refinancing the loan. Depending on the terms and interest rate of your new loan, you may be able to offset any fees imposed by your previous lender while saving money.
If you have a simple interest auto loan without pre-payment 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.