I saw a video explaining that principle payments helps save money by paying less interest and paying off your loan faster but I’m still confused as to how.
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If there’s a lower balance on the loan, there’s less interest being charged since the balance subject to interest is lower
The principle is how much you currently owe. The interest payments are calculated based on the principle, specifically as a percentage of the principle. So the larger the principle, the larger the interest payment. If you can make an extra payment or a larger payment here and there, you’re making the principle smaller. A smaller principle means the next round of interest payments will be smaller.
Others have provided good explanations.
Another way to look at the total cost of the loan is: multiply the monthly payment times the total required payments, and then subtract the original loan amount (ex. $10,000 loan for 24 months, $450/month payment would mean that you will pay $10,800 to borrow $10,000; you could reduce the $800 cost by reducing the principle – the sooner in the loan term you reduce the principle, the more you save because the interest is calculated monthly on the existing principle)
Let’s use round numbers and simplify greatly. The big thing isn’t about paying more, but about keeping interest payments down.
You owe $12,000. You make $500 a month payments. You pay interest on what’s left to pay first, so at 10% annual interest you pay $100 ($1,200 yearly divided by 12) and then $400 to what you owe.
Next month you owe $11,600, so your interest payment will be slightly less, $96, meaning $404 goes to pay off the loan. Each month you’re paying off the loan faster because more is going to what you owe.
But say that first month you paid an extra $500. So $100 went to interest and $900 went to pay what you owe. Now you owe $11,100, so the next payment will be $92 to interest and $408 to what you owe.
The faster you drop what you’re paying in interest, the faster you pay what you owe, which cycles back around and drops your interest even more.
On the opposite side, missing that first payment adds that $100 interest to what you owe, which means more of the next payment goes to interest, which means you’re not just a month of payment behind, you now have a higher balance you’ll keep paying interest on.
Because you pay a % of interest on the total value of the car.
Let’s say I bought a big wheel for $100. I only pay $1 a month at a 10% interest rate, which is $10. So I pay $1/month plus $10.
Next month, I’m paying 1% interest on $99, instead of $100 the next month so the interest is only $9.99 instead of $10 but still HIGH. At the end of 100 days, I’ve paid a LOT because I chose a long loan term. The longer you pay and the less your payments, the more you pay overall because of interest.
Now, if I got a $25 check from grandma for my birthday and pay it toward the PRINCIPAL, I will only owe $75. You have to specify that it’s for the principal or they will just cover $25 worth of payments, don’t forget that. So if I do that, I now only owe $1 and $7.50 instead of $9.99. I’ve just saved myself $25 worth of interest payments, aka a LOT of money.
Many car loans are in the 30% interest rate area.
I once had a car payment that was $75/month interest. Since, once I realized, I’ve paid off every car early by making principal payments of every spare dollar I got.
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