When it comes to taking out a loan, on anything, it is important to understand exactly what terms you are agreeing to before you sign on the line. You’ll want to understand what those monthly payments broken down are paying for and how much of that payment is going towards the interest rate that you agreed to.
What Is The Loan Principal?
The principal of your loan is the amount of the loan that was taken out. This usually includes taxes, fees and titling in addition to the cost of the vehicle, less of course however much you put down as a down payment. So if you bought a car for $10,000 and put down $1000 and financed the rest (i.e you took out a loan for $9000) then the principal amount of your loan will be $9,000. Your monthly payments won’t just cover this amount.
Keep In Mind
You will also pay interest and you will pay it monthly. Interest is the cost associated with borrowing money. Because no lender is just going to hand you free money! The structure of how your loan is repaid will vary from lender to lender so be sure to read the contract and find out how the lender structures repayment and how much of your monthly payments will actually go towards the principal amount of the loan.
When you request to borrow money for a vehicle (it is recommended that you get pre approved before going through the car buying process!) the lender will pull your credit background and evaluate your income to ensure you will be able to meet your monthly payment amount.
After you have been approved for the loan, keep in mind that you are going to pay taxes, title and license fees as well as dealership fees if you buy through a dealership. It is important to consider these costs when considering how expensive of a vehicle you wish to buy as well as what your hard line will be in terms of negotiation if you are trying to push your budget to your approval limit.
Taxes alone can be 10% or even more of your vehicle price depending on what state you live. To be on the safe side you should be aware of what your state charges for taxes when agreeing to a vehicle price.
What Is The Difference Between Paying Down Interest And Paying Down Principal?
Remember you’ll agree to a price before you get your loan in most dealership settings and the other way around in private party sales. YOU NEED to know what you are agreeing to in the financial contract before you sign it. Many car dealerships will advertise a monthly rate that you’ll pay for a financed car but sometimes they slipped in added fees to that amount. Do not sign until you read.
Now that we’ve gotten that out of the way let’s discuss what your payment gets broken down into. Most car payments are amortized style loans which means you’ll have a fixed monthly payment and a simple interest rate that shows how much interest you will pay throughout the life of the loan. In these loan structures you will find that that a large portion of your initial payments go towards paying off interest alone and a smaller portion goes toward the principal amount. This is pretty standard.
Over the months that you make payments that ratio will reverse and toward the end of the loan you will be paying off your principal in larger chunks. It is important to note that your interest rate and your monthly payment amount will not change! You just have less of the principal amount left so the interest structure will be lower.
Can You Pay More Toward The Principal Amount?
Yes! You can pay off your loan more quickly by making larger payment amounts and chipping away at your debt at an accelerated pace. If you do this, specify that you want these extra payments to go towards your principal amount! This is the only way to ensure that you are paying less money overall in interest.
What To Know About Loan Interest
Interest is the cost associated with borrowing money. Time value of money states that a dollar today is worth more than that same dollar in the future. This is due to inflation as well as investment income potential. The lender is only going to agree to lend you money based on the money they are going to make in the process.
A lender will structure a loan with either a simple interest rate or a compounding interest rate. In a simple interest rate, which is what most auto loans have, your interest is calculated on a daily basis based on the remaining principal amount on the loan. The interest is not collecting interest. The interest isn’t going to accrue over the life of the loan.
In a compounding interest loan which is very unlikely in the auto loan industry, the borrower will pay interest on the principal of the loan as well as on the interest. This means the interest amount is always getting bigger. Examples of this type of interest which many consider to be predatory lending styles include credit cards and student loans.
How To Pay Off Your Loan Early
As we discussed above, you can pay more than your standard monthly payment amount if you have a simple interest rate loan. However you should be aware that some lenders will not allow you to pay off the principal amount any earlier because it reduces the income that they make on the loan. Be sure to look into this crucial detail before signing for your loan if paying off your loan early, and saving money on the interest you will pay over the life of the loan is of interest to you.
If you’ve confirmed that your lender will indeed allow you to pay more per month toward your principal amount, there are several ways to go about paying off your loan early if your income and budget will allow for it:
- Round up your monthly payment to the nearest whole $100. Similarly to investing apps that take your purchases and round them up the nearest whole dollar and invest the difference. It can make a big difference simply paying the extra $49 or whatever amount per month to round up the payment amount.
- Pay off your loan biweekly instead of once per month. If you can afford it and it is coming out of your principal amount, you should try to pay off your loan as quickly as possible using more frequent payment schedules. Heck, pay it every week if you can afford it. You can possibly save yourself thousands of dollars in interest.
- Consider your refinancing options.
Auto Loan Payoff Calculator
If you want help calculating your loan amount and how much per month will go to your principal amount (including if you want to make higher principal only payments!) check out this awesome loan payoff calculator from Bankrate.com. This calculator is specifically designed to help people understand auto loans before or after they sign for one. Check it out using the link here.
If You Want To Save Even More Money, Consider Refinancing
People refinance loans for all sorts of reasons and you can refinance both home and auto loans. In some cases people need to adjust their payback period in order to lower their monthly payment amounts, in other cases people are trying to save themselves money.
You’re reading this for the latter reason. There are two ways that you can save yourself money by refinancing a loan:
- You agree to a new loan, with new loan terms, that has a shorter payback period with an equivalent or lower interest rate.
- Your credit situation has improved greatly and you are now being offered a lower interest rate.
Either way, the idea is simple, save yourself money by reducing the overall cost of borrowing money AKA paying less in interest.
Refinancing For New Loan Payback Period
If your current loan won’t let you pay back extra money toward your principal this is a great way to go. Refinance your payback period and your monthly payments will go up, just make sure that your interest rates are staying the same and you will be saving yourself a ton of cha- ching by doing this. Remember only commit to a monthly payment that you can afford to avoid repossessions and dings to your credit. If you are living month to month and don’t have a 6 month supply of liquid cash to pay your bills if crap hits the fan then this isn’t advisable.
Refinancing Because Your Credit Situation Has Improved
As you pay off your loan over time, if you are making all of your monthly payments on time, as well as keeping current with your other bills then its likely that your credit score is going up! Of course, on time payments are just part of the credit reporting process and if your income has gone down or your debt has gone up (or both) this may not be the case. Check your credit history using a reporting service. If your credit score has gone up more than 30 points it might be worth considering refinancing your loan.
Finding Extra Money To Up Your Monthly Payment Toward Principal
Another way to pay off your car loan faster is to put any extra money you can find or earn toward your car loan. Here are some ideas:
Utilize Tax Refunds, Work Bonuses and Pay Raises
Yes it is going to hurt putting these “extra” income streams towards your debt, however you will have more money in your pocket in the long run by utilizing this tactic. Again, just make sure you are paying off the principal of the loan to reduce interest payments.
Putting your raise is an especially easy way to up the amount you pay off on your car every month. You don’t have to change your budget or standard of living one bit. If you are comfortable now, just imagine how much roomier your budget will be when your car is paid off AND you get to utilize that raise.
Think of it this way, the faster you pay off your car, the more quickly you will free up your budget for going out to eat, going on vacations or buying a house. It is worth the sacrifice people!! Or if you are cheap like me, imagine putting that extra cash every month into retirement savings, your investment portfolio or just your regular old checking account for a rainy day.
Reduce Your Budget
Sure going out to eat with your friends is great, but if anything the Covid-19 pandemic has taught us is that we can do without those luxuries. Instead of going out to eat with friends, make a meal in together. If you sit down and evaluate your budget, most of us have wiggle room to cut out the extra fat. If you aren’t seeing any of this wiggle room I’m talking about, see what you can do to reduce your monthly bills like cell phone or cable. If you aren’t willing to cut out the unnecessaries consider these other options.
Eliminate Monthly Subscriptions To Save More Money
If you’re still looking to put more money away per month towards a car, consider getting rid of some of those monthly subscriptions. Yes I know you have them!
Personally, I have 5 or 6 subscriptions that I pay for on a monthly basis, and after I finish this article I’m going to go and evaluate which of these that I really don’t need. I implore you to do the same. The average American spends almost $80 per month. That means over half of you reading this spend more than that!!!
Imagine how much more quickly you could save for your next car by eliminating these costs from your budget. I’m not expecting you to get rid of ALL your subscriptions (yes you can keep your Netflix account), but see what you can do to get rid of some of them and put that extra $50- 100 per month towards your savings account.
Get A Part Time Job
If you are still desperately trying to find room in your budget to save for a car, consider getting a part time job. Even if you are waiting tables just one night out of the week, you can make an extra $300-800 per month depending on the restaurant and the night of the week that you work. If you can spend your Sunday mowing your neighbors yards, start a small part time business.
There is plenty of money in this world, all you have to do is be creative about going out and earning it. If you have something that you are passionate about, see if you can make some extra dollars on the side doing what you love. Even if you aren’t passionate, you can do this side hustle temporarily while you save for your car. I’ve had neighbors pay me to pick up their dog poop filled yards. If you want it, go get it.
Snowball Your Debt Payments
Taking this approach can help you pay off all of your debts, including your car loan. You can thank Dave Ramsay for this one.
The first step in snowballing your debt payments is to pay as much money as you can to the debt that is costing you the most in interest or you can pay off your smallest debt item first to eliminate it and get it out of the way. Once that debt is paid off move on to the next item on the list that meets this criteria and continue doing this until all of your debt is paid off. Just make sure the other debt you are taking car of as you start this process is on minimum payments.
Snowballing your debt is the most effective way of paying off debt because it helps you eliminate as much in unnecessary interest payments as you possibly can. The key here is to put yourself on a payment plan and utilize a budget to meet these goals. Whatever you do, do not take on new debt (if possible) during this process.
Sell Your Car And Buy Something Cheaper
So this goes without saying. If you can’t afford the car you are currently in or you want to save more money by paying less toward a loan, call your loan provider and see if you are able to pay off your principal amount in full.
Take the money you are saving on the interest you would have paid and buy yourself a less expensive car. As someone who paid under $4,000 for their last vehicle, I will tell you that you would be shocked at the value you can get on a car for between $3000 and $10,000. Shop around and see if you don’t believe me and if you really want to save money then buy your next vehicle used from a private party seller.
So there you have it, above you’ve read the best ways to not only pay off your principal loan payment, but to budget yourself and pay off as much of your debt as quickly as you can. Using these tips you can get yourself out of the rat race and start building real and measurable wealth. Good luck!
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