Looking to finance a car but will be able to pay off principal over time. Since loans are structured to pay off interest first, how’s is my rate changed based on the interest I have already paid? Is that money lost or will my new monthly payment account that I owe less money and I’ve paid for more interest than I actually needed to (assuming rates are the same)
If I pay off principal on a loan, how does that impact future payments based on interest I have already paid
DebtLoans are not structured to pay off interest first. Every dollar extra you pay you no longer pay interest on that dollar
Since loans are structured to pay off interest first
Looks like you need a refresher on how loans work.
Say I take out a fictional loan of $10k at 12% interest. Each month, my interest is calculated based on the remaining principal balance using a very simple formula:
(remaining principal balance) x (interest rate) / (12 months)
So my first payment will accrue ($10k x 12% / 12months) = $100 of interest. If my minimum payment is $200, then that means I first pay that $100 of interest, and the remaining $100 will pay down the principal.
So the next month I calculate my new interest accrual as ($9.9k x 12% / 12months) = $99. I again pay my $200 minimum payment, which pays the $99 of interest and then $101 goes to paying down the principal.
So the third month, we keep going and calculate my new interest accrual as ($9,799 x 12% / 12months) = $97.99, meaning my minimum payment then pays down $102.01 of principal.
and that repeats until the loan is paid off. This process is called amortization. In the case of a car loan specifically, interest accrues daily instead of monthly, so all that does is changes is you accrue 1/365 of your interest rate per day, multiplied by the number of days, but the same general principal applies.
So if you make an extra principal payment, all that does is change that (remaining principal balance) number in that equation. it means that you will accrue less interest than you would have if you didnt make the principal only payment, which means more of your payment will go towards principal, which accelerates how quickly you pay off the loan.
how’s is my rate changed based on the interest I have already paid?
Unless you have a variable rate loan, you rate doesnt change.
and that repeats until the loan is paid off. This process is called amortization. In the case of a car loan specifically, interest accrues daily instead of monthly, so all that does is changes is you accrue 1/365 of your interest rate per day, multiplied by the number of days, but the same general principal applies.
I have never heard of a car loan that compounds daily.
The more that you put towards principal, the faster the loan is paid off. It moves you further along the amortization chart so that the next payment has a higher % of principal as opposed to interest. The money isn't lost.
Loans are arranged in such a way that the payment is fixed because you have a principal and computed interested. Money up front can change your monthly as it reduces the principal (and therefore the interest paid over the agreed upon time frame).
Money on the back end just makes the loan shorter because extra payments go to the principal, so you pay it off faster….but it doesn’t change your monthly. If your loan is X/month for Y months and you pay 2X one month you will still owe X every month, but for Y-1 months.
It is Y-1 months only if your 2X payment is the second to last payment. The earlier you make the 2X payment, the less time it will take to pay off the loan.
Right, I simplified the math a bit just to get the point across.
Here is an early loan payoff calculator if any ody wants one.
https://www.dinkytown.net/java/loan-early-payoff-calculator.html#
Most car loans are set up based on the following criteria:
- Total amount financed (or principal)
- Interest rate
- Number of monthly payments
These criteria set your monthly minimum payment. Once they are set, the interest rate and the monthly payment are set for the duration of the loan.
Interest is charged on a monthly basis, based on the remaining principal. Assuming no late payments, the monthly payment should always cover the interest accrued, plus some principal. That is why, at the beginning of the loan, the largest percentage of your monthly payment is going to interest, but over time, it trends towards principal.
Assuming there are no prepayment penalties, paying extra on principal will reduce the principal for the next interest calculation, that is how it saved you interest. And it also means a larger percentage of your monthly payment goes towards principal, not interest.
Paying extra on the principal does not change the monthly payment. It either means you pay off the loan sooner, or they apply it to the next due date. So when you do make an extra payment, a lot of times you need to be very specific to tell them to apply it to the principal, not the next due date.
1 missing reply
You might not know how amortization works.
The interest you pay is based on the remaining principal. The more you pay down the principal, the less interest you'll pay each month.
The interest rate never changes unless you refinance the loan (OR if you have something like an Adjustable Rate Mortgage, which is rare these days, at least in the US). Again, you gradually pay less and less interest over time, but that's because there is less principal accruing interest, not because the actual rate changes.