For many people, getting out of debt as quickly as possible is a major goal. Making extra payments can go a long way toward helping you get rid of your debt faster while saving you money on interest.
However, as you go about making extra payments, it’s important to understand how they work. The way you make your payments can make a big difference in how quickly you get out of debt. No matter how you do it, any extra payment is a good thing that will save you time and money, but there are ways to save even more money when you use a principal-only payment.
Here’s what you need to know.
What is a principal-only payment?
Normally, when you make a payment on a loan, the lender applies part of your payment to interest and fees before it reduces the principal.
Let’s say your monthly payment amount on a $5,000 loan at 6% APR is $96.66. Your interest payment is $13.33. So, before anything is applied to your remaining balance, part of your payment just goes toward interest and $83.33 goes toward reducing the principal.
If you make an extra payment during the month, in many cases the lender still uses the same formula. So, the lender would add up the interest accrued during the month and use a portion of your payment to pay the accrued interest before applying it to your principal.
A principal-only payment, on the other hand, is one that goes entirely toward reducing the principal. Because the amount of interest charged is based on your principal, your interest charges become smaller as your principal is reduced.
A principal-only payment can accelerate your debt pay off and save you money in interest. This is especially true with credit card interest since many credit cards compound interest on a daily basis. If you can make an extra principal-only payment on your credit card each month, your interest will accrue much slower, helping you get rid of your credit card debt that much faster.
How to make a principal-only payment
Making a principal-only payment can be a bit tough. Not every lender allows these payments. Additionally, it’s important to note that some lenders will allow you to make extra payments during the month, but if you don’t specify that the payment should go to the principal only, you might still see a portion of the payment go toward interest fees.
If you want to make an extra principal-only payment during the month, start by checking with the lender. Each lender has its own process for making these payments (if they allow them). You might be required to make your extra payment at the same time you make your regular payment. In some cases, you might need to get an extra payment slip and check a box that says, “principal-only.”
Automate your payments
When possible, the best way to make your payments is to automate them. Some lenders allow you to make an extra automatic payment each month, specifying that each extra payment goes toward the principal.
If you can set this up online or over the phone, it can help you tackle your debt without the need to remember to make an extra payment each month.
Watch out for prepayment penalties
Realize that some lenders won’t allow principal-only payments. You can make extra payments each month, but they won’t apply them solely toward the principal. However, in these cases, there’s still a benefit to making the extra payment because you will still get out of debt sooner.
On the other hand, there are lenders who not only don’t allow you to make principal-only payments, but they also charge prepayment penalties. So, if you pay off your loan early, you might be charged an extra fee. These lenders try to recoup some of the lost interest from your accelerated payments by charging you a fee.
Before you begin making extra payments, run the numbers. See if there’s a prepayment penalty and, if there is, whether your interest savings are big enough to offset the fee.
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How a principal-only payment reduces your debt faster
To give you an example of how much you can save by making principal-only, let’s take a look at $15,000 car loan that has a four-term with 5% interest.
Using Money Under 30’s Extra Payments Loan Calculator, you can expect to pay about $1,370.72 in interest if you keep making payments on the loan until it reaches its full term. However, by making extra payments, you can get rid of the loan quicker and save money on interest.
If you make an extra payment of $100 per month, you’ll save $210.40 in interest.
While it doesn’t seem like a huge difference, the savings are more dramatic the bigger and longer the loan term is. The interest rate can also make a difference in the impact of extra principal-only payments. The more you can take off the principal at a time, the more you save in interest.
It’s also worth considering one-time principal-only payments, even if you can’t make regular extra payments. If you get a bonus or a tax refund, putting that money toward a principal-only payment can put a dent in what you owe, as well as reduce your interest fees because there’s a smaller balance to charge interest on.
What about bi-weekly payments?
If you’re not sure you can make an extra payment each month, you can reduce the interest you pay and the time you spend with debt by making bi-weekly payments instead. Divide your monthly payment in half, and set up your account to pay every other week. You’ll make 26 payments a year. That adds up to one extra monthly payment a year — without the need to strain your budget.
Realize, though, that when you make bi-weekly payments, you often end up paying principal and interest for each payment. Your lender doesn’t usually count one of your payments as principal-only. However, you can still save over your regular term, getting out of debt earlier and paying less in interest when you use bi-weekly payments.
If you have the money to make extra payments on a bi-weekly basis, the impact can be even bigger. You can save more money and be out of debt sooner when you combine extra payments with bi-weekly payments. Review your budget to see what you can manage.
No matter your situation, making extra payments on a loan each month can make a difference in how much you ultimately pay in interest. Depending on the circumstances, the ability to make principal-only payments can give you an even greater edge by allowing you to pay off your debt a few months earlier and save in interest.
Don’t feel like it’s not worth it to make extra payments if you can’t make principal-only payments, though. The reality is that any extra payment — as long as there aren’t hefty prepayment penalties — can be a great help as you tackle your debt.