How and why to make principal-only payments on your car loan

If it’s possible for your budget, paying extra towards your auto loan can be a good idea. Making principal-only payments on your car loan can help you build equity, save on loan interest and pay off the loan faster.

But make sure you allocate extra payments in a way that saves you the most money. If your lender won’t apply extra payments to your principal, you won’t benefit as much.

What is a principal-only car payment?

The principal on your car loan is the sum of money you borrowed from the lender. Your typical monthly car payment goes toward what you owe on the principal, the accumulated interest and loan fees. The lender usually applied the monthly payment to fees and interest first. Any remaining amount from your monthly goes towards the principal.

Paying extra money towards the loan’s principal is called a principal-only car payment. Every lender handles extra payments differently, but often, you will need to specify how you want extra payments to be applied.

Benefits of making principal-only payments

When you make extra payments on the principal, you save on your interest over time. For instance, with simple interest loans — which make up the vast majority of car loans — interest is a percentage of the total principal you owe. And as you reduce the principal amount owed, your accrued interest becomes less and less.

By comparison, when extra payments are applied to the interest, you’re not reducing the total amount the loan will cost you. Only by paying down the principal will you reduce your interest expenses on this type of loan.

Note that there is less of a financial benefit to making principal-only payments with precomputed interest loans, which are less common.

Every payment that goes solely toward your principal builds equity in your car. As you build equity in your car, you get closer to owning it outright. It also reduces the risk of owing more than your car is worth — also called being upside-down on the loan.

If I pay extra on my car loan, does it go toward the principal?

When you make extra payments on your car loan, it’s important to know how the lender applies these payments.

Ideally, you want your extra payments to go towards the principal amount. However, many lenders will apply the extra payments to any interest accrued since your last payment and then apply anything left over to the principal amount. Other times, lenders may apply extra funds to next month’s payment.

It’s a good idea to call the lender to find out how they will apply the extra funds and, if possible, specify how you want the money used. You can also look at your loan contract to find out how a lender applies extra payments.

How to make a principal-only payment

Before you make a principal-only payment, check with your lender to see if it allows this type of payment and how to go about making one. Some lenders may apply the payment to the principal automatically.

However, lenders usually require that you let them know when you make the payment that it is for the principal only. This may only require that you check the principal-only box when you make a payment online. Other times, the lender may ask you to make this request in writing.

If your lender doesn’t offer the option to make a principal-only payment, you may still be able to pay down your loan faster.

How to pay down your car loan faster

If you can’t make principal-only payments, you may still be able to pay off your car loan ahead of schedule. Make sure your lender doesn’t charge prepayment penalties before making additional payments.

• Schedule biweekly payments: You may not have the money to make a whole payment twice a month, but making a half payment every other week can cut down on the overall interest paid, depending on how it’s calculated. Remember, this only works out if it is a simple interest auto loan, as precomputed interest will be applied the same regardless of when payments are made.
• Pay a little more than your minimum payment each month: Check with your lender to see if it allows this type of payment and how to go about making one. Every little bit helps when it comes to paying down the loan faster.
• Make extra lump-sum payments: If you get a bonus or tax refund, you can put it towards your car loan if it wouldn’t be better spent elsewhere.

Bottom line

If you have the means, making principal-only payments on your auto loan is the most effective way to save on your car loan. Contact your lender to find out if they accept payments like this. If they do, ensure you know how they want you to alert them when you make a principal-only payment.

Remember that every bit counts when it comes to paying down your loan. Adding any extra payment to your regular monthly payment can help you pay off your loan faster.