Almost half of all Americans used a loan to purchase their car. While the vehicles and terms associated with those loans vary greatly, all borrowers have one thing in common: they want to save money. However, to save money on your auto loan, it’s essential to understand exactly which part of the debt your loan payment is going towards.
Auto loans are generally made of two parts: the principal and the interest. While they are typically paid together, they satisfy different aspects of the debts respectively. Read on to learn which one saves you the most money in the long run.
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What Is the Loan Principal?
A car loan principal is the amount of money you borrowed from your lender. In most cases, this is the price of the vehicle, the tax on your purchase, any dealer fees, the cost of purchasing the title, and licensing fees.
If you find a $20,000 car you want to buy and borrow the entire $20,000, your loan principal will be $20,000 plus any extra purchase fees. If you have $10,000 to use as a down payment on the vehicle, your principal will be $10,000 plus your additional fees.
Paying the Principal on a Car Loan: What Does This Mean?
Your auto loan payment is broken into the principal and interest. The principal is the amount you borrowed or the amount remaining on the loan. The interest is what a lender charges you for taking out a loan.
Each time you make a loan payment, part of that payment goes toward interest and the principal. Paying down the principal means you’re paying more money on the principal than is required at that time.
Check your loan terms or ask the lender in advance to determine if you can make extra payments on the principal and ask them how to do it. Each loan is a bit different. While most auto loans allow you to pay additional amounts on the principal, the lender might require you to make those payments differently. A few loans do not let you pay down the principal, and you might even incur prepayment penalties.
Paying Down Principal vs. Paying Down Interest
Most auto loans charge simple interest, computed by looking at the balance owed. You can reduce the balance owed by paying off the principal more quickly. This reduces the interest you pay throughout the loan, saving you money in the long run. It’s one of the reasons people like to pay down the principal when they can.
Your auto loan payment is divided among a few different buckets. The first bucket is any interest you owe up to that point; the next is any additional fees you might have incurred, like late payment charges, and then your payment is applied to the principal.
If you pay more than required for the month, your “overpayment” might not automatically reduce your principal. Instead, it will go toward any late payments and fees or next month’s interest. Talk to your lender to learn how to apply additional payments to your principal.
Benefits of Principal-only Payments
If you make extra principal payments toward your car loan, there are some significant benefits.
First of all, you control how much you’ll pay. Taking out a longer-term loan will mean lower monthly payments. If you can afford to pay more, you can apply it to your principal, but you still have a cushion if you cannot afford to pay extra.
Another benefit of paying down the principal is that you’ll save money over the life of the loan. Finally, you’ll build equity in the vehicle more quickly. This is great if you want to trade it in or sell it sooner.
Pay off the Loan Faster
If you have a simple interest car loan with an interest rate higher than 0%, making additional payments toward the principal reduces the amount you owe more quickly. This approach pays off your loan faster.
Pay Less Interest
Some auto loans use precomputed or compounded interest models. These loans do not benefit from principal-only payments. The good news is that most auto loans have a simple interest model, where the interest due is based on that day’s loan balance. If you can reduce your loan balance, you pay less interest.
Considerations With Principal-only Payments
Right now, paying down the principal of your auto loan might seem like a great idea. It is for many people, but not always. There are some situations where paying extra toward the principal is not beneficial.
There are no interest charges if you have a 0% loan, so a prepayment on the balance does not save any money. It will reduce the loan length, but you might be better off having that money available rather than using it for the loan.
Research how interest is computed before making a principal-only payment. If you have compounded or precomputed interest, you’ll be paying the predetermined interest charges, no matter what.
There are other situations where principal-only payments are not to your benefit.
Prepayment Penalties
Some loans have prepayment penalties; if this is the case, you’ll be charged a fee for paying off your loan early. This is because your prepayment resulted in fewer interest payments going to the lender. They hope to recover some of that lost income by charging a prepayment penalty.
Ask if there are prepayment penalties before you take out a loan or make any principal-only payments.
Other Higher-interest Debt
One thing to consider when you’re trying to pay down your debt is the interest rates. Auto loans usually have a lower interest rate than credit cards. You’re paying more money out of pocket when you have high-interest debt. It makes more financial sense to pay off your high-interest debt first.
Paying Down the Principal vs. Refinancing
If you’re looking for a way to lower your car payment, reduce the loan length, or cut back on interest, you might want to refinance your auto loan.
The term refinancing sounds like you’re adjusting your old loan, but you’re taking out a new one. Refinancing requires research to get favorable loan terms, loan length, and interest rates – just like starting a brand new loan. Not doing research can cost you money in the long run, so it’s not a step to skip.
You Want a Loan with a Shorter Term
When refinancing, one of the first things to consider is the loan’s term or length. Refinancing is a good option if you are stuck with a loan that still has years left and does not want to be stuck paying for a vehicle that long. This requires higher monthly payments, but you will not be stuck with such a long term on your loan.
You Can Secure a Lower Interest Rate
You will typically benefit by refinancing to a lower interest rate if you have a high-interest rate with your current car loan. Make sure to watch out for any prepayment penalties with your existing loan. Paying that loan early, even if you’re refinancing, can trigger prepayment fees.
Which Strategy Is Right for You?
Your loan terms give you the best insight into whether paying down your principal is the best option or if a refi is the better choice. Check your current terms to see if there are prepayment penalties, how many months remain on your existing loan, and your interest rate.
A prepayment penalty will hit your finances, but it does not mean you cannot refinance or repay your loan early. For instance, if you discover that paying off your loan early or refinancing saves you $2000 over the life of the loan and the prepayment penalties are only $500, it’s a good idea to refinance or pre-pay your loan because you’re still saving money.