Let’s cut to the chase: making extra payments each month on a personal loan can dramatically lower the amount of interest you pay over time.
The main reason for this is because interest is based on principal — a lower principal amount means less interest, and you save money. For this reason, principal-only payments should be explored and considered by everyone who has a little extra wiggle room in their budget.
What is a principal-only payment?
There are basically three types of payments you can make on any debt: amortized payments, interest-only payments and principal-only payments. An amortized payment is a normal monthly payment where your money goes towards both principal and interest. Interest-only payments are optional with some types of debts where you pay the interest up front for a set period of time before working on the principal.
Now let’s talk about principal-only payments.
When you make a principal payment, all of your payment goes towards lowering your principal, which in turn lowers the amount of principal on which interest accumulates. It’s not an option with every type of debt, and it does involve a few extra steps on your part, but it’s great if you can do it.
Let’s say you have a five-year loan of $10,000. Your interest rate is 6% and your monthly payment is $193.33. If you were to make no extra payments, the total amount of interest you would pay in five years would be $1,599.69, which would put the total cost of the loan at $11,599.69 without fees.
However, let’s assume you double what you pay each month by making an extra payment— meaning that instead of only paying $193.33 each month, you pay $386.66 in total. Not only does this cut down on the total amount of interest you’ll pay over the life of the loan to $735.27, but it will also cut down your monthly payments to two years and four months. You save yourself two years and eight months’ worth of payments and $864.42 in interest.
Understanding interest rates
Lenders make money off of loans by charging interest. In the above example of a $10,000 loan with a 6% interest rate, the lender turned $10,000 into $11,599.60 within five years. It’s great for them, but not so great for borrowers.
To calculate what you pay in interest, you must first divide your interest rate by the number of payments you’ll make in a year. Then, take the quotient and multiply it by the loan principal. The result is what you’ll pay in interest.
( APR / Number of Payments) x Principal Amount = Monthly Interest
Example: for a $10,000 loan with 6% APR, the first month of interest will be $50.
( 0.06 / 12) x $10,000 = $50
To figure out how much will go towards the principal, subtract what you pay in interest and fees from your monthly payment. The rest goes towards your principal.
$193.33 – $50 = $143.33
$10,000 – $143.33 = $9,856.67 (new principal after first payment)
Note: Each month the amount you pay in interest will change because your principal changes with each payment. So for the second month, you will use the formula above to find the monthly interest payment and use $9,856.67 instead of $10,000. The interest payment for the second month of the loan will be $49.28. Every month, the amount of interest you pay will decrease as the principal amount decreases.
Should I make a principal-only payment?
If your lender allows it and you can afford the extra monthly expenditure, then yes, you should endeavor to make principal-only payments on your debt. If you’re consistent with it, it can shave off a lot of time from your payment timeline and save you a lot in interest. (If you’re not concerned about interest, you should be. It’s a lot more than you think.)
Once you start, it’s not a necessity that you do it every month. You’re not entering into a new payment schedule by making an extra payment. You can simply do it as your budget allows, paying as much as you wish whenever you wish.
However, many lenders don’t allow principal-only payments. So before you attempt to make a principal-only payment, you need to contact your lender to see if it’s permissible. If you don’t, you run the risk of your extra payment being amortized just like any other monthly payment— meaning the extra money will still go towards interest before hitting your loan’s principal.
If you don’t see extra payments advertised anywhere online, call and speak with a representative. Not too many people even consider making extra payments on their debt, so even though the company may allow it, there may not be the option online to do so.
Are there any prepayment penalties?
Oftentimes, lenders do charge prepayment penalties so they are still making a profit off of the principal loan. The amount of the prepayment penalty depends on a lot of factors, some of which include the amount of your loan and your interest rate. The lender may simply charge a flat fee, but each lender is different.
It also depends on how aggressive you are with your prepayments. Read the fine print, but it’s often possible to make a principal-only payment here and there without receiving any penalties from your lender. Of course, if you can’t find anything, don’t be afraid to call and speak with a representative.
Benefits of principal-only payments
Making principal only payments can help you out a few different ways. Here’s how:
- Lower the amount of interest you pay. The amount of interest you pay is based on your principal. The lower your principal, the less you pay in interest. If your lender allows you to make consistent principal-only payments, it’s possible to save a lot of money in interest.
- Get out of debt faster. Making extra payments each month quickly lowers what you owe because more of it goes towards your loan principal and less of it goes towards interest. If you can, doubling what you pay each month can cut your pay-off period by half.
- Improve your credit score. Part of your credit score revolves around debt. The less debt you have in your name, the better your credit score will be.
- Increase other financing opportunities. Though you don’t want to get out of debt just to get back into it, it’s always good to have access to funds if you need it. Lenders will see your strong history with credit, and will be more likely to approve you for financing.
Are principal-only payments a good way to reduce debt quickly?
Yes. And you don’t even have to double your payments to see the benefit.
Consider a $10,000 principal, with 6% interest rate and five-year pay-off period that requires a monthly payment of $193.33. If you were to just pay an extra $100 every month, you would:
- Pay $991.05 in interest as opposed to $1,599.69
- Pay the loan off in three years and two months, as opposed to five years
The total cost of the loan would be $10,991.05. Without making extra payments it would be $11,599.69. That’s a lot of money, but the biggest benefit is getting out of debt one year and 10 months before scheduled.
Furthermore, just throwing an extra $50 has its benefits, too. Doing so would pay off the debt in three years and 11 months, while saving you $377.51 in interest.
Do bi-weekly payments help reduce debt?
Instead of making one normal monthly payment, you split what you would normally pay each month in half with a bi-weekly payment plan. Therefore, you’re not paying more money each month, but you are making more payments by the end of the year.
A normal borrower makes 12 payments a year towards debt. By making payments every two weeks, you will make 26 half-payments, which equates to 13 payments a year. Doing this will save you a few bucks in interest with a $10,000 loan. Instead of paying $1,599.69 in interest you would pay $1,438.99, which is a savings of $160.70.
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