For most people, a new car purchase is a special event that comes after weeks or months of research. Unfortunately, this research does not often include the amortization payment schedule that most car loan lenders use. This means that many Canadian car buyers like yourself often end up paying off their car loan for much longer than they actually need to. This is because a part of the monthly instalment goes toward paying down interest, which leads to two outcomes:
- Your car belongs to the bank for a longer period of time.
- The interest on the loan causes you to owe the bank a lot more money.
The key to avoiding both of these scenarios lies in understanding the difference between standard car payments and principal-only payments. In this article, we’ll explore how car buyers can pay down principal instead of interest and pay off their car loans much faster at a lower cost.
What Are Principal-Only Payments?
The concepts we’re about to discuss can be confusing, so let’s use an example to help us understand. Let’s say you bought a car that costs $30,000 CAD (inclusive of taxes, title, and fees), and your down payment was $6,000. This leaves us with the principal amount of $24,000. However, since borrowing money isn’t free, the bank will also charge you interest. If your bank agreed to an interest rate (APR) of 6% for a loan duration of 24 months, then the payment schedule should look like this (figures rounded off):
Loan Principal Balance
All seems well until you realize that the loan principal balance, which is essentially the amount remaining on the loan each month, isn’t decreasing as much as it should. That is, the balance is reduced by $944, $948, $953, etc., but not by the full $1,064.
This is because a percentage of your monthly loan repayment is applied to the principal, while another portion (in most cases, the more significant amount) is applied to fees and interest. The former is called paying down principal, and the latter is referred to as paying down interest. This is the main reason the principal balance decreases at a snail’s pace despite all the payments you make.
Since this is how lenders make their money, the repayment schedule is designed to maximize interest. As a result, on a $24,000 car loan with a 6% APR over two years, you will actually end up paying just over $25,500—an additional $1,500. This additional interest payment is far greater in longer duration loans.
The form of interest most commonly applied to car loans in Canada is simple interest, but there are other types of interest as well. Below is a brief explanation of the three main types:
- Simple interest: If, for example, there is a balance of $7,500 on the initial $24,000 loan, the lender calculates interest on the $7,500 balance.
- Precomputed interest: Lenders use a specific formula to calculate the interest at the beginning of the loan period, and the charges remain constant regardless of your loan balance.
- Compound interest: Lenders who use compound interest charge on both your principal balance and the accrued interest. This means that the interest you pay on your car loan continues building on itself.
How Can You Make Principal-Only Payments?
The good news is that you can avoid paying extra interest by specifically paying down the principal. The first step in making a principal-only payment is to check with your lender or bank to see if such a payment method is available to you. Generally speaking, the type of interest charged by your lender determines whether or not you can make these extra payments. As long as your lender charges simple interest, you can reduce the interest owed by making advance payments. That said, you should still speak with your lender beforehand because contracts can differ.
Furthermore, making principal-only payments isn’t as simple as giving more money to the lender. Instead, the process involves sending a formal request to the lender clarifying that the extra amount is to be applied to the principal, or else the lender could still apply the payment to the interest.
Making an additional principal payment will enable you to clear your car loan before the maturity date. Over time, these extra principal payments will reduce the amount of interest owed on every subsequent payment you make. If you make your principal-only payments together with your regular monthly repayments, you may need to specify the purpose for the additional amount.
Unfortunately, principal-only payments do not apply when your lender uses the precomputed interest formula. Since the interest is precalculated, it remains the same whether you make any extra payments or not, meaning your lender won’t reward your efforts to lower the principal.
Alternatives to Principal-Only Payments
As we said, not all lenders offer the option of making principal-only payments. In these cases, there are still a few ways to pay off your car loan faster while paying less interest.
One of the most popular methods is to refinance your car loan. In essence, refinancing means applying for a new loan to replace your existing loan. People usually refinance car loans if their credit score has improved, making them eligible for lower interest rates and help them save on car payments.
Car buyers will often refinance to shorten the loan duration period. For example, switching from a 72-month term to a 36-month term will increase the monthly payment but reduce the total interest paid over the entire loan term, although the APR will remain the same.
However, refinancing may not be an option if your credit score has decreased because you have made lower payments or if your car loan is new.
Benefits of Making Principal-Only Payments
The peace of mind that comes with paying off a loan may not be easy to quantify, but there are several other quantifiable and concrete benefits that come with making principal-only payments. These include:
1. Reducing the Total Interest Paid
How much interest you pay a lender depends on your loan principal balance—the lower the principal, the less interest you pay. If your lender allows it and you have the means, it’s possible to realize substantial savings on interest by making consistent principal-only payments.
2. Full Ownership of Your Vehicle
Car loans are a type of secured loan where the collateral is the vehicle itself. This means that until the loan is fully paid off, the lender or bank is the owner of your car (the title). You own your vehicle free and clear once you’ve paid off your car loan.
3. Increased Financing Opportunities
Your credit score is determined, to a large degree, by how much you owe. Your credit score improves when you have a smaller amount of debt in your name. While there is little incentive for paying off one debt to take on another, you’ll want to have access to extra funding when you need it. Lenders are almost always willing to approve financing for individuals with a strong credit history.
It’s also important to note that since credit scores are based on credit history, closing an old account (such as a car loan) may result in a lower credit score in the short term. That said, over time, your credit score should become higher than it was before the closure.
Drawbacks of Making Principal-Only Payments
As great as principal-only payments are, there are a few drawbacks that you should take into consideration.
1. Prepayment Penalties
Some lenders attach a prepayment penalty to the loan agreement. This means you are charged a fee for paying off your loan sooner than scheduled. Lenders include this clause to recoup a percentage of the interest they had projected to collect from your loan over its full term.
The amount charged as a prepayment penalty varies from one lender to another. In most cases, an occasional principal-only payment rarely triggers a penalty. The prepayment penalty mainly applies when you pay off the entire principal balance well in advance or when you pay off a large percentage of the loan at once. It’s a good idea to confirm with your lender how they apply the prepayment penalty and consider whether prepayment is still a financially viable option for you.
2. Fewer Funds/Opportunity Cost
Like every other financial decision, you should consider the opportunity cost. Making an additional payment will mean you’ll pay less interest, but it also means that you’re spending money that you could have used for other essential purposes, such as building an emergency fund.
Principal-only payments become less attractive when there are principal-only fees (these are different from prepayment penalties). In such a scenario, you may be better off clearing your other high-interest debts, such as credit card payments and student loans, before rushing to clear your car loan.
Conclusion & Recommendation
Generally speaking, it’s a wise decision to make principal-only car payments if you’re looking to pay off your car loan faster. However, as we’ve seen, there are various elements to consider when making this decision. Ultimately, whether you choose to make principal-only payments on your car loan will depend on your situation and factors such as the availability of a prepayment option, the fees and penalties involved, your credit portfolio, and your financial goals.