When it comes time to get an auto loan, you’ll want to have a solid understanding of the difference between what it means to pay down the principal on an auto loan and what it means to pay the interest rates. Understanding the various parts of your loan could help you make money-saving decisions.
what is the principal of the loan?
There are several moving parts in a car loan. the lump sum of money you borrow to pay for the vehicle (and sometimes your taxes and fees) is the principal. You will also pay interest, which is what it costs to borrow the principal. Auto loan structure varies by lender: Generally, part of each monthly payment goes toward both interest and principal.
Reading: Paying principal on car loan
When you ask a lender for money to buy a car, you evaluate your financial situation to make sure you can afford the monthly payments that include the price of the car plus interest charges.
principal payment vs. interest payment
Most traditional auto loans have a fixed payment schedule that typically spans five to six years. During the first few months of your loan, a large portion of your payment goes toward paying what is known as simple interest. this portion decreases over the life of the loan. in the end, almost all of your payment goes towards paying off the principal.
For example, imagine you have a $500 car payment over 60 months at 2.5% interest.
- first payment: $441 goes to principal and $59 to interest
- last payment: $499 goes to principal and $1 goes to interest
See also: What to Do After a Car Accident
If you make additional principal-only payments, you can shorten the length of the loan and reduce 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 each month toward 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 car loan using the lenders car affordability calculator.
how to make principal payments only
Paying off a car loan early can be beneficial. however, not all lenders allow principal-only payments, so be sure to check with yours if this is an option. doing so reduces the amount of money they earn on your loan.
Once you’ve confirmed with your lender that you’ll apply amounts above your regular monthly payment to the loan principal, you can make larger payments than usual or send additional money when your budget allows.
here are a couple of tips on how to do this:
- make a car payment every two weeks instead of once a month. by dividing your regular monthly car payment in half, you’ll pay the equivalent of one extra payment each year , which will reduce your principal and the total amount of interest you’ll pay.
- round up your payment. if your regular car payment is $329, round up to $400. If you’re having trouble getting the extra money, you may be able to earn additional income and/or cut expenses with these tricks.
pay principal vs. refinance
Instead of making principal payments solely on your existing loan, there are times when replacing it may make more financial sense. refinancing your auto loan may be a good idea when:
is ready for a loan with a shorter term.
You can pay less total interest that way. As an example, if your loan payment amount is $39,000 at 3.99% interest and you have been making monthly payments of $702 for about a year, you might decide that you want to refinance to a 36-month term rather than finish your original payment. 72-month term. this could save up to $2,088 over the life of the loan. And even though 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 get a lower interest rate.
Maybe your credit score has improved since you got your original auto loan. For example, if you took out a 60-month, $20,000 auto loan at 5.9% interest and have 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 an interest rate of 1.99%, 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 better loan term may be the only way to pay off your car loan early. You can use our auto refinance calculator to see if refinancing is right for you.
Before making a decision, it’s important to know if you’ll be charged a prepayment penalty. There is no point in paying off a loan early if doing so will cost you more. But if you can get a competitive term and interest rate on an auto refinance loan, you may be able to offset the fees imposed by your previous lender and save money.
If you have a simple interest auto loan with no prepayment penalties and your lender allows you to pay down the principal, it may make sense to keep your current loan and work to pay it off early.