Why Is Most of My Car Payment Going Towards Interest Instead of Principal?

Car loans of all the loans out there (in our opinion) are THE WORST. 

They are expensive. They are typically tacked with the worst terms imaginable. They are expensive (wait, said that one already.)

But if you are like the millions of people out there who have one, then you may have noticed something particularly crazy— Your monthly car payments aren’t making a dent in your total loan balance owed. 

Here’s why. 

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How the payoff of a car loan works

When you take out a car loan it's made up of two parts; principal and interest. 

Principal is the price you paid, the sticker price, the price you saw online. Not included TTL (tax, title and licensing fees). 

What is the interest on a car loan?

Interest is the amount you pay to borrow money. This is true for a car loan, a student loan, a mortgage, everything. This is what interest is. 

Interest example:

You want a car. The car is $10,000. Do you have $10,000 in cash (statistics say you probably don't.)

What do you do? Either you save, you borrow from a friend (aka seller financing) or you join the masses and you finance your car through a bank or other lender. 

The catch? You now owe them for the gracious loan. What do you owe?-- Interest. 

How is interest calculated?

Interest is calculated based on a set rate. But it's not as simple as multiplying the rate by your total loan amount. This is where it catches you. Here’s an example of the WRONG way interest is calculated:

Car loan amount = $10,000

Interest APY) = 8.65%

Interest for the loan: $10,000 x 8.65% = $865

This would be true if the interest were applied to the entire balance up front and then divided by the amount of months on the loan. 

But that is not how it's calculated!

How the interest is ACTUALLY calculated

You see here is the stick– interest is applied month after month on the remainder of your outstanding balance. On top of this, in the beginning of your loan a majority goes towards interest (so the lender can make sure they get their cut up front). So your balance isn't budging much and neither is your interest on the loan. 

Here's how this shapes up:

• Car loan amount = $10,000
• Interest APY = 8.65%
• Loan term = 6 years (72 months)
  

Here’s the first four months of payments:

As you can see the total interest paid is rising but the balance is barely budging over the first four payments. And this is how it happens each month for the first few years depending on the length of your loan. 

And after your first year:

• Total Amount Paid in 12 Months: $2,142.24
• Interest Paid in 12 Months: $813.13
• Principal Paid in 12 Months: $1,329.11

So out of $2,142.24 you paid in your first year (21.42% of your entire loan at $10,000), only $1,329.11 of that went to your actual car loan amount. 

Why does most of my payment go to interest?

Most of your payments go to interest due to a payment structure known as front-loaded interest payments, also known as amortization. 

In summary, front-loaded interest payments (for car loans) mean that earlier payments are predominantly used to pay off interest rather than reducing the principal amount. 

This structure is beneficial for lenders (obviously) because it limits their risk and ensures early profitability, but it also means that borrowers see a slower reduction in their principal balance during the initial stages of their loan term.

How do I make sure my car payment goes to principal?

Pay extra. Typically, if you pay extra this will hurry the process along. This won’t always work, it depends on your lender. 

But most times anything paid over the regular payment is applied to the principal. Again, ask your lender. If there are prepayment penalties in your lending contract you could have a whole different problem on your hands. 

Do extra car payments automatically go to principal?

Yes for some lenders, but not for every lender. Some can even charge you a fee for making extra payments. Sounds illegal right? Well in some states it actually is. 

But extra payments will either do one of two things;

1. It will attack your principal (the best)
2. It will be applied to next month's payment (Not ideal.)

What happens if I pay an extra $100 a month on my car loan? 

Paying an extra $100 will help knock down your car payment significantly over time. Let's assume that you don’t have a prepayment penalty clause in effect. Here’s what will happen if you pay an extra $100 each month on the car loan example from earlier.

Here’s that original monthly payment - $178.52 (original payment) + $100 (extra) = $278.52.

Now, here's the new timeline for your loan payoff and the total interest you'll pay with this adjusted payment.

• Total Interest Paid Over the Loan: Approximately $1,614.
• New Loan Term: About 42 months (3.5 years) to pay off the loan.

This means, by paying an extra $100 per month, you would not only reduce the total interest paid from around $2,700 (as per the original terms) to approximately $1,614, but you would also pay off the loan in about 42 months instead of the original 72 months.

How does paying $100 extra each month on your car loan help you?

• Reduced Principal: The extra $100 directly reduces the principal balance of your loan. This means the outstanding balance you owe decreases faster than it would under the regular payment schedule.
• Less Interest Over Time: Since interest on a car loan is calculated based on the remaining principal balance, reducing the principal faster means you'll accrue less interest over the life of the loan. Essentially, you’re shortening the amount of time your principal balance is higher, so less interest accrues.
• Shortened Loan Term: By consistently paying extra, you’ll be able to pay off the loan faster than the original 72-month term. The exact reduction in your loan term depends on how regularly you make these extra payments and the terms of your loan.
• Reduced Total Cost of the Loan: By paying off your loan faster and reducing the total interest, the overall cost of the loan decreases. This means you end up paying less than you would have if you only made the standard payments.

4 Tips for paying off your car loan early

1. Don't overspend: To begin with, get a car that's comfortably within your budget. Aim for the 20/4/10 rule. 
   1. Pay 20% down
   2. Don't take a loan for more than 4 years
   3. Don't spend more than 10% of your gross income
2. Buy used: Unless you are just doing it big with no debt and a wad of cash leftover each month to splurge, do yourself a favor– buy used. Plus a car that is used has already depreciated from the huge jump that it takes from new to used. 
3. Pay bi-weekly: Paying biweekly is not just a trendy hack it adds up in one of two ways:
   1. If you pay bi-weekly with half payments (your usual payment cut in half): This extra payment is applied to the principal, reducing the loan balance faster. A lower principal means less interest accrues over the life of the loan, and you can pay off the loan sooner than the original term
   2. If you pay bi-weekly with full payments: This (clearly) significantly reduces the principal balance at a much faster rate, drastically reducing the total interest paid and shortening the loan term considerably.
4. Refinance: Say you made the mistake of buying a pricey ride on top of getting high interest. You can now see how that is going to make your payoff much much worse. Here’s the good news– you can refinance. By lowering your interest you lower your overall payment and you can shorten your payoff if you maintain your same payments.