What Happens If You Make One Extra Car Payment a Year?
Learn how one extra car payment a year can significantly reduce your total interest paid and shorten your car loan term.
Making one extra car payment each year can significantly impact the overall cost and duration of a car loan. This article explores the mechanics of car loans, details the financial advantages of an extra payment, outlines the process for making such a payment, and explains how to verify its correct application.
Understanding How Car Loans Work
A car loan involves borrowing money, the principal, to purchase a vehicle. Lenders charge interest, typically calculated as an annual percentage rate (APR), as the cost of borrowing. Your monthly payment, constant throughout the loan term, is divided between paying down principal and covering accrued interest.
Most auto loans operate on a simple interest basis, meaning interest is calculated daily on the outstanding principal balance. In the early stages of a loan, a larger portion of each monthly payment goes towards interest, with a smaller amount reducing the principal. As the loan progresses and the principal balance decreases, less interest accrues, allowing a greater share of each payment to be applied to the principal. This process, known as amortization, gradually reduces your loan balance until it reaches zero.
The Financial Benefits of an Extra Payment
Making one additional car payment per year reduces the total interest paid over the loan’s life. Since interest is calculated on the remaining principal balance, any extra payment directly lowers this balance sooner. This reduces interest accumulation in subsequent periods. For instance, on a $25,000 loan at a 6% APR over 60 months, an extra payment can save hundreds of dollars in interest and shorten the loan by several months.
This strategy accelerates the amortization process, allowing more of your regular payments to go towards the principal earlier. The earlier in the loan term an extra payment is made, the greater its impact on interest savings. This chips away at the principal when the interest portion of standard payments is highest. Paying down the principal faster also builds equity in the vehicle more quickly, beneficial for selling or trading the car before the loan ends.
How to Make an Additional Payment
Initiating an extra payment involves contacting your loan servicer or utilizing their online payment portal. Lenders offer options for one-time or recurring extra payments. Common methods include direct debit from your bank account, paying online through the lender’s website, or mailing a check.
An important step is to explicitly instruct the lender to apply any additional funds directly to the principal balance. Without clear instructions, some lenders might apply the extra amount as an advance on your next regular payment, which would not immediately reduce principal or save interest. Select a specific online option, check a box, or state your intention to a representative. Before making any extra payments, confirm with your lender if there are any prepayment penalties, though these are uncommon for typical auto loans.
Verifying Payment Application
After making an extra payment, it is important to verify that the funds were applied correctly to your loan’s principal balance. This ensures you receive the intended financial benefits. The most direct way to verify is by reviewing your next loan statement, physical or online.
Look for a clear indication that your principal balance decreased by the extra payment amount. Some statements might show an updated amortization schedule or a revised payoff date, reflecting the accelerated payment. If the online portal or statement does not provide sufficient detail, contact the lender’s customer service directly to confirm how the payment was allocated. This ensures your efforts to reduce interest and shorten the loan term are successful.