How to Pay Towards Principal on a Car Loan
Take control of your car loan. Understand how to effectively pay down principal, reduce interest, and accelerate your payoff.
A car loan involves borrowing money from a lender to cover a vehicle’s purchase price. This borrowed amount is referred to as the principal. Over the life of the loan, borrowers make regular payments that include both principal and interest. Understanding how to manage the principal can empower borrowers to manage their car loans more effectively.
The Value of Principal Payments
The principal in a car loan represents the initial amount borrowed to purchase the vehicle, excluding any interest or fees. For instance, if a car costs $25,000 and a borrower makes a $5,000 down payment, the starting principal balance would be $20,000. Most car loans operate on a simple interest basis, meaning interest is calculated daily on the outstanding principal balance.
By making extra payments directed towards the principal, borrowers can reduce the total interest paid over the loan’s duration. Since interest is calculated on the declining principal balance, lowering this balance sooner means less interest accrues daily. This strategy also leads to a faster loan payoff and helps build equity in the vehicle more quickly.
How to Make Extra Principal Payments
To ensure extra funds are applied directly to the principal, clear communication with the lender is essential. Many lenders may automatically apply extra payments to future scheduled payments, which does not reduce the principal or save on interest. Borrowers should specify that any additional money is a “principal-only payment” to lower the outstanding loan balance.
One method involves adding extra money to the regular monthly payment, indicating it’s for principal. Some lenders provide an option to designate this online or require a written note. Alternatively, borrowers can make separate, one-time lump sum payments if they receive a bonus or have extra savings. Making bi-weekly payments, which are half the monthly payment every two weeks, effectively results in one extra full payment per year, often applied to principal.
Key Steps Before Making Extra Payments
Before making extra principal payments, review the loan agreement for any prepayment penalties. While uncommon for car loans, they can exist. Confirming the absence of such clauses ensures financial benefits are not offset by additional fees.
Understand the lender’s policy for applying extra payments. Some lenders offer online designation, while others require a phone call or written instructions. After making an extra payment, always verify on your loan statement or with the lender that funds were applied to the principal. This confirms the payment is reducing the loan’s principal and saving interest.