Can I Apply a Partial Payment to the Principal of My Car Loan?

Interest on most car loans is simple. The larger your principal balance, the more of your payment goes to pay for interest rather than reducing that principal balance. That means that reducing your principal can be the magic bullet to paying less interest over the life of your loan. In most circumstances, you can do this by applying extra or partial payments to your principal balance. Knowing the terms of your loan and how interest works can save you time and money.

Per Diem

Most car loans operate on simple interest, which means that interest accrues over time, but is not capitalized, or added to your principal balance. This interest accrual is based on a simple formula: principal balance x interest rate x time. The first part of this equation will give you your daily interest per diem, or the amount charged each day. This per diem is then multiplied by the number of days since your last payment, which yields the amount of interest outstanding on any given day. Lowering your principal amount reduces this per diem, which results in less interest paid over time.

Principal Only

Contact your lender to determine the best way to make a partial or principal-only payment. If you manage your loan online, many financial institutions now offer the ability to pay more than your minimum payment or to make an additional payment. If it is not clear that these additional amounts will be applied to principal, confirm with the lender themselves before submitting the payment, as it may be difficult to have the payment reversed.

Early Payment Penalties

Before making any additional payments, review your original loan documents to ensure that there are no early payment penalties in your contract. Some lenders require that the initial payments all go to the interest that would be paid over the life of the loan before any amount goes to principal. This would negate the benefit of principal only payments. Other contracts may charge a percentage of the outstanding amount as a pre-payment fee. Be sure that you are not in either situation before calculating the benefits of extra or principal only payments.

Side Effects

In addition to pre-payment penalties, be sure to discuss any other unintended consequences to making extra or partial principal payments with your banker. In some cases, the extra payment may go to satisfy future payments in addition to or in lieu of paying down your principal. If you arranged to have your payments made automatically, your next payment may be reduced due to the extra payment you made this month, which may prevent you from paying your loan down as quickly as you had intended.