Should I Pay Principal-Only on a Car Loan?
Explore the strategy of making extra car loan payments directly to principal. Understand its impact and whether it aligns with your financial situation.
A car loan is an installment loan that allows you to borrow money to purchase a vehicle. You repay this borrowed amount, known as the principal, along with accrued interest, over a set period through fixed monthly payments. The vehicle itself often serves as collateral, with the lender holding the title until the loan is fully repaid.
Understanding Principal-Only Payments
A principal-only payment is an extra payment specifically directed towards reducing your car loan’s outstanding principal balance. When making a regular monthly payment, a portion first covers fees and accrued interest before the remainder applies to principal. In contrast, a principal-only payment bypasses the interest portion, going directly to decrease the core amount you borrowed. This immediately lowers the loan’s foundation, distinct from simply paying extra on your regular bill. Lenders might hold extra payments to cover future installments instead of reducing principal.
How Principal-Only Payments Change Your Loan
Applying extra funds directly to the principal balance impacts your car loan by reducing future interest charges. Since car loans typically use simple interest, which accrues daily on the unpaid principal, lowering that amount means less interest accumulates each day. This leads to a decrease in the total interest paid over the loan’s life. Accelerating principal reduction can also shorten the overall loan term, allowing you to pay off the car earlier.
Key Considerations for Your Financial Situation
Before making principal-only payments, assess your broader financial standing. Establish an adequate emergency fund, typically covering three to six months of living expenses. This financial cushion prevents needing to borrow at higher interest rates or falling into debt during unexpected challenges. Compare your car loan’s interest rate with other outstanding debts you may have, such as credit cards or student loans. If these other debts carry substantially higher interest rates, prioritizing them may lead to greater overall interest savings.
Additionally, review your car loan agreement for any prepayment penalties. Some lenders may charge a fee for paying off a loan early, which can be around 2% of the outstanding balance, particularly for loans 60 months or shorter.
Steps to Make a Principal-Only Payment
To ensure an extra payment applies directly to your loan’s principal, clear communication with your lender is necessary. Most lenders do not automatically apply extra funds to principal, often applying them to future scheduled payments instead. You may need to specify your intention through their online payment portal, where an option like “principal only” might be available. Another method involves contacting the lender directly via phone. For check payments, writing “principal only” on the memo line can indicate intent, but always confirm the lender’s policy.