Buying a car is a huge milestone and commitment, and the sheer cost of a vehicle typically requires taking out a car loan you’ll repay over time with interest. You generally pay auto loans back in equal monthly installments over the duration of the car loan terms. Several factors affect the amount of this monthly payment, and once it’s set in stone, not much can change it.
Paying principal is a great way to pay off your car loan faster, but it won’t usually affect your monthly payment expectations. Your loan will remain on the same fixed payment schedule unless you refinance.
Paying off the principal faster than expected, however, could reduce your overall car loan term without changing the monthly payments. It would take fewer total months to pay off what you owe.
Paying principal comes with advantages and disadvantages. While it’ll never decrease your required monthly payment, the benefits it does offer might be worthwhile depending on your financial circumstances. Learn everything you need to know about paying the principal on your car loan.
What Is Principal on an Auto Loan?
The principal on an auto loan or any other loan is the amount of money you borrowed. For a car loan, it’s the amount you borrowed to purchase the car. This includes the price of the car itself as well as fees and taxes included with the purchase. Any money you borrow to cover the purchase of the car is part of the principal.
Put simply, the principal on your car loan is any part of your loan that isn’t interest. The annual percentage rate is the only aspect of your loan separate from the principal, and your loan payments cover both the principal and the APR.
Generally speaking, most car loans require you to pay off a lot of the interest first, with the principal being covered closer to the end of your car loan term, regardless of your credit score. The amounts for both will be clearly noted on your car loan documents.
Lowering Principal
Before you think about paying off the principal of any loan early, try to get that number as low as possible so you have less to pay interest on. You can take several steps to reduce the principal from the outset.
Put Extra Money Down
The down payment on a vehicle goes directly toward the vehicle, which is part of the principal. The larger your down payment, the less principal you’ll have to pay.
Cover the Taxes
Car loans often include taxes and other fees for titles and licensing. You can pay these costs upfront to reduce your loan’s principal value.
Trade in an Old Car
In lieu of making a substantial down payment, you can trade in an older vehicle you own. You can then put the value of that vehicle toward the new one. With both a trade-in and money down, the amount remaining to pay off is significantly less.
Opt for a Cheaper Car
We all have dream cars, but it’s financially smarter to opt for the most affordable vehicle that still offers everything you want. A new sedan can be loaded with exciting features and still be more affordable than the speedy sports car with less interior space and fewer infotainment options.
Advantages of Paying off Principal
It’s important to recognize that paying off principal will not lower your monthly payments. In fact, it will mean you’re paying more each month. Putting extra money toward your car loan, however, offers some benefits.
Shorter Loan Terms
Paying extra payments toward the principal in your car loan will shorten the overall length of your loan. While you’ll be paying more every month, you’ll be paying the loan back for fewer months total. You’ll also build equity much faster.
Less Interest
With the car loan principal decreasing, total interest decreases, as well. Interest payments always decrease over the life of the loan, but paying off the principal with extra payments will cause the interest payments to reduce even faster.
Disadvantages of Making Principal-Only Payments
When paying principal-only payments on your car loan, be aware of a few downsides to determine whether this strategy makes financial sense for your situation.
Prepayment Penalties
Some lenders charge a prepayment penalty if you pay off the loan earlier than stated in your loan agreement. With these penalties, the potential savings you get from avoiding the extra interest are offset, rendering your efforts useless. Lenders do this to recoup potential losses on the interest they would’ve otherwise received.
High-Interest Debt
Paying off your auto loan faster isn’t nearly as important as paying off other high-interest debt you might have, such as a personal loan. Credit cards, for example, often have higher interest rates than auto loans, so that’s something you’ll want to prioritize. Essentially, principal-only payments are only feasible options for those who don’t have other outstanding debts that could get in the way.
How to Make Payments toward Principal
Every month, a portion of your loan payment goes toward the principal automatically. You’ll need to send extra to make additional principal-only payments. This is only applicable if you don’t have overdue payments. Any extra you pay while behind will automatically go toward bringing you back up to date. Check out some options you have for making principal-only payments:
Make an Extra Payment
Making an extra payment is a simple yet effective way to bring down your principal. Simply contact your loan company and tell them you’re going to make an additional payment toward the loan, provided your contract doesn’t include penalties for doing so. Even doing this once a year or at least once during the loan term is helpful.
Pretend Your Loan Term Is Shorter
Assume you have a 60-month loan. With all the information from your loan, you can use an auto loan calculator to determine what your monthly payments would be for a 48-month loan. If you can pay that, do so.
You’ll only be legally obligated to pay the minimum payment set in your 60-month contract, but you’ll be blazing through your loan at a speed that’ll have you done in 48 months. This also provides some breathing room in case you have an emergency payment come up elsewhere in your life.
Make Extra Half-Payments
While you’re only required to pay a once-monthly car payment, you can make bimonthly car payments if you like. An extra payment every two weeks doesn’t have to be equal to your required regular payment. Instead, strive for half-payments to make it less of a financial burden.
Chip Away
Chipping away at your balance is easy to do when you round up. For example, assume your monthly payment is $342.98. Round that up to $350 or even $400 and you’ll be chipping away steadily at your principal.
Pay off a Large Portion at Once
If you find yourself with extra cash, use it to pay off part of your principal in a lump-sum payment. Whether you got a bonus at work or a surprise inheritance, this is an effective way to cut down on your principal balance or potentially cover the entire thing.
How Can I Lower My Car Payment?
Paying off principal can potentially save you money, but it won’t lower the minimum payment per month expected by the loan company. One way you can lower your payment, however, is by refinancing your loan. In fact, certain circumstances might make it more fiscally responsible to refinance rather than try to pay off your principal.
Refinancing Basics
Refinancing your auto loan means replacing your existing loan with a new one. In this scenario, your original loan balance is paid off and you begin payments toward the new loan. This can result in a variety of benefits depending on your unique financial situation. Find out the benefits of refinancing:
Lower Interest Rates
If your credit has improved since you took out the original loan, you might be able to refinance for a lower APR. While this could reduce your payments, it could also help pay off your loan faster for around the same monthly payment, essentially functioning the same as making extra payments toward your principal.
The difference is you might be able to refinance at a lower interest rate while also making extra payments toward your principal, which drastically decreases the overall loan term.
Shorter Loan Term
Refinancing doesn’t always decrease your monthly payments. In fact, it can increase your payments if you opt for a shorter loan term. A shorter loan term, however, means you won’t be paying as much interest over the duration. Unlike the prepayment penalty incurred by paying off your car loan early in some scenarios, refinancing doesn’t come with penalties.
When Should I Refinance?
Several changes in your life and income could warrant refinancing your auto loan rather than paying off the principal if you want a lower car payment. Refinancing certainly isn’t the best option for everyone, but several circumstances can make it a no-brainer.
Your Credit Score Increased
Lenders will always look at credit scores when deciding what kind of loan to give you. If your credit score increased significantly after you obtained your original loan, refinancing could lead to serious savings with lower interest rates and a reduced monthly car payment.
Interest Rates Decreased
Interest rates vary based on the lender and your credit score, and, of course, general trends can affect the entire industry. If interest rates drop by 3 percent or so, that might be significant enough to save you hundreds on your total overall payments. Just make sure to check the math using an auto loan calculator to see if it’s worth it for your personal circumstances.
The Monthly Payment Is Too Much
While it’s nice to refinance with a better credit score or lower interest rates, it might also be a good idea for people who start to have trouble paying off their initial loan. While refinancing solely to get a lower monthly payment might cause you to pay more overall due to the extra interest that comes with extended loan terms, a lower monthly car payment might ensure you can cover rent and electricity.
You Got Your Loan from a Dealership
Dealerships aren’t always the most generous when it comes to financial services. They’re in the business to make as much money as possible, and if you didn’t know your credit score or typical interest rates before financing with a dealership, they might have given you a bad deal. Do some research to determine the best deal you can get with your credit score and interest rate trends in mind.
Elizabeth Rivelli is a freelance writer with more than three years of experience covering personal finance and insurance. She has extensive knowledge of various insurance lines, including car insurance and property insurance. Her byline has appeared in dozens of online finance publications, like The Balance, Investopedia, Reviews.com, Forbes, and Bankrate.
Source: www.caranddriver.com