Paying extra on your auto loan can save you money as long as the lender applies the payment to the principal of the loan. To make sure this occurs, you should always send a note with the payment telling the lender to put the payment toward the principal and not next month's payment. If you pay down the principal, the interest you pay decreases each month, so more of your regular payment goes toward the principal, as does the extra payment. This saves you money and accelerates the payoff of the loan.
Pay the Principal
Car loan payments consist of two parts – the principal and interest. The principal is the actual amount of the loan and the interest is the cost you pay for the loan broken down into monthly payments. A portion of each payment goes toward the principal and another toward the interest. If you make your regular payment plus a principal only- payment, the interest that accrues during the following month is based on the lower principal amount.
Lessen Your Loan Payoff
Making principal-only payments accelerates the payment of your loan and decreases the interest you pay over the life of the loan. For example, you can save almost $900 in interest by paying an additional principal-only payment of $100 a month on a 60-month loan for $20,000 with a 7% interest rate. You'll also payoff your car loan one year and one month faster with the extra $100 payment.
Let the Lender Know
The key to using this payment strategy is communicating with your lender when you make your payments. To assure the lender applies the principal-only payment properly, write two different checks or make two electronic payments each month. Notate that the second payment is a principal-only payment and direct the lender to put it towards the principal. It is also a good idea to verify the payment went toward the principal by calling the lender. Unfortunately, some lenders will continue to misapply the principal-only payments as it is in their best interest financially to continue receiving more interest.
Learn the Limitations
Some lenders do not allow principal-only payments, so be sure to find out the details on prepayment or early payoff penalties before you take out the loan. Fortunately, some states require lenders to offer principal-only payments and other lenders allow them anyway. If you are already in the midst of a car loan and want to start making extra principal payments, read your loan documents carefully. Then, contact your lender to discuss how you can get them to put the extra payments toward the principal. Some lenders require you to mail payments to an alternative address or pay by phone if it is a principal-only payment.