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Paying Down Principal

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Can I admit something that may make me sound like a real dummy? (It’s okay, I’m secure enough with my own intelligence in other domains that I’m okay with admitting when I’m totally out of my depth in something.) Plus, it’s something that I’m hoping many of the readers here will be able to educate me on and help me with. Here goes…..

You know how I’ve been making larger-than-minimum payments on my car for several months now (since last August to be precise)? Well, I logged in to check on the status of my balance for my last debt update and realized that it said my next due date isn’t until January of 2016!!!

In other words, instead of applying any additional money toward the principal balance, they were simply pre-paying future payments. I had thought (and was wrong), that they only pre-paid for up to 3 payments, and then extra money went straight to principal. So after discovering this error I called customer service and explained the situation, asking for my extra payments to go toward the principal instead of future payments.

I was assured this would be done, but it would take a few days (so my online account hasn’t been updated yet), and I was told that it wouldn’t actually change my balance at all.

I started thinking about it after we hung up and have thoroughly confused myself.

Aren’t most loans (cars, mortgage, etc.) arranged so you pay mostly interest up front? Toward the end of the loan terms you end up paying more principal, but initially almost the entire payment goes to interest, right? So basically I’d just be pre-paying mostly interest. Sooo, if that money gets reallocated toward the principal, then there’s a lower balance for the interest to be compounded on (or capitalized on? I’m so confused!). Right? Soooo, shouldn’t my balance go down then??? No?? Why not? I don’t understand!

Also, I was thinking about it more and trying to figure out what the actual benefit is of paying more toward principal versus simply pre-paying payments (particularly if there’s no difference in the balance). I’ve always heard that if I make extra payments (for car loan or student loans) that I should request for the extra to go toward the principal. But why? I was so off-put by the fact that I don’t know the answer to this that I started googling…..without much luck. When I googled “why should I put extra money toward principal instead of prepaying a loan?” I received a ton of results related to mortgages and student loans. I’m specifically interested in my car loan, but figured the numbers would be the same so I read some of the articles. From what I could gather, it seems like if you pay the principal first, it basically just shortens your loan term (so if you had a 60 month term, like my car, it may end up getting shortened down to a 48 month term). But wouldn’t this also inherently decrease the amount interest being paid? I mean, you’re paying it off sooner, so you have a lower balance for the interest to be compounded/capitalized on (again – no idea the difference between capitalized vs. compound interest), and then eventually you pay it off and it all just goes away. Right? And it’d be the same thing with pre-paying a loan too, right? You pay it off sooner, meaning less interest gets paid in the end because there are fewer months for which to have interest accumulate. Am I totally off on this?

I almost shudder, knowing that so many of you are probably bonking your heads against the computer screen, shouting at my ignorance.

But, yeah. I really don’t know. And I don’t get it, either.

Please enlighten me! I really want and need to understand this difference, particularly with my huge amount of debt!!

And, relatedly, I’m going to start paying extra on my student loans. My plan is still to focus on other debts first, but I need to at least pay the interest on my student loans so the balances don’t keep growing (remember, my minimum payments are so low that they don’t even cover the interest). In reference to this….when I make an extra payment, my intention is really just for it to cover the interest. So I can just make the payment online and leave it alone, right? Or do I need to call and ask that the extra payment be applied to principal? This whole issue with prinicipal balance, interest payment, and loan pre-payment has really thrown me for a loop! Help me sort it out!!!

Seriously, sorry for my ignorance on this matter! Clearly I do not have a background in finance! But to really take charge of my debt I feel like I need to get my mind wrapped around this better. Do you suggest any good personal finance books? Or any good websites or other resources that have been informative for you?

Ashley

Texan at heart; Arizonan on paper. Lover of running, cheese, camping, and family (fur-family included!). Blogger, motivated to get out of debt YESTERDAY! Follow along with my journey!

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16 Comments

  • Reply Alexandria |

    Ashley – I don’t have much advice because I have never had any loans outside of a mortgage. Which is the same as a car loan, but with mortgages they have never just sent my payments to cover future months. So I don’t know how common that is or anything.

    & as to your ignorance, trust me, the vast majority of people are fairly ignorant on this stuff. & I think it is GREAT to educate yourself.

    Yes, if you pay down extra principal it lowers the interest you pay and it decreases the balance, accordingly. Which in turn pays off the loan faster. Someone else can explain student loans to you but I can explain car loans. Say your balance is $1,000 and your interest rate is 5%. $1,000 x 5% = $50. Divide that $50 by 12 and that figure ($4.17) is the interest you owe for the month. The difference will go to principal. You will have to re-calculate interest every month based on the new principal balance.

    This is also why I mentioned a while back that I Was skeptical if your “interest rate” was really that low on the license fees. Say you paid 3% with every payment. (I don’t remember the actual rate). If you do that 12 times per year it’s really an effective 36% interest rate. If you have a 3% interest rate that is just the interest you pay over the course of the year. It’s not 3% every month.

    I hope that helps!

    • Reply Ashley |

      Wow, I remember your comment from several months back, but totally didn’t “get” what you were saying at the time, but you’re totally right! I’m going to be giving an update on the license fees soon, but to give a brief update here the fees are actually interest-free, but they charge a service charge every time I make a payment. The fee that is charged depends on the amount being paid (the lower the payment, the higher the charge is as a proportion of the payment. The highest it goes is 2.5%, but it goes down from there). Regardless, you are correct that this sounds like it would actually be much higher than a 2.5% APR on a credit card or car loan or something, due to the way the interest is calculated, versus the way this service charge works.

      • Reply Alexandria |

        That said, now that I think about it, the fee is only on the portion you pay, for the license fee. The fee is not on the entire balance, like interest would be. Maybe paying smaller sums with a smaller fee percentage makes more sense??? Maybe that makes more sense from a financial standpoint but not sure about that from a sanity standpoint. I am sure you just want to be done with it!

        I guess I am retracting my comments that your “interest” on the license fees may be much higher.

  • Reply MB |

    I think it is OK. So you have prepaid your payment until Jan of 2016, So your current balance is what it would be in January 2016 if you followed their payment chart. Keep making those payments and pretty soon you will be “prepaid” until the end of the loan. So if the schedule last load payment is say March of 2017. Keep paying ahead until you are “prepaid” until March 2017. If they are using simple interest, Which I think Hubby’s loan are, then there will be some recalculation of the amount owed. Can you look up your “payoff blance”? Keep track of that and watch it go down…

    • Reply Angie |

      This is not sound advice. Prepaying your payments is still causing you to pay the full interest on the term of the loan even though you are paying early.

      Interest is typically calculated based on your balance each day. It just usually is summed at the end of the month with your payment. This is why months with less days (February) have lower overall interest than other months with 31 days.

      If you prepay you want your balance to go down immediately so subsequent days get charged less interest.

  • Reply nsheils |

    Ok, this post might help you get a better understanding of how payments are applied.

    https://www.reddit.com/r/personalfinance/comments/2tulai/it_isnt_your_banks_fault_it_takes_so_long_for_you/

    People often misinterpret how their payments are applied as “front loaded” interest. It’s not actually front loaded, it’s just that your higher principle balance accrues more interest when the principle amount is higher, so more has to go toward interest.

    I don’t know how it is in your case, but with my student loans, many aren’t due for at least another year, but my payments continue to decrease the principle. It’s good that you double checked with your lender, but you may have just wiped out a buffer for yourself if they get rid of your prepaid status, which should have also been paying down your principle.

    Did you check to see if your principle amount was indeed going down, regardless of the prepaid status?

    • Reply Ashley |

      Thank you for the link! I’m going to check it out later tonight! I’d have to check about the principle amount going down. I believe it has, indeed, gone down, but I’m curious to see how it all looks once it’s been updated (applying the extra payments directly to principle versus going to prepayments). I still don’t “get” why the customer service guy said that it wouldn’t make a difference with my balance. Why? Shouldn’t it make a difference if the money is going toward pre-payments versus principal only?? Still so confused!

      • Reply Nsheils |

        It might not make a difference to your balance because it has been decreasing your principle all along. Have you been checking on whether or not your principle has been going down?

        And in many cases your payment is going toward pushing out your next payment due date as well as decreasing your principle.

  • Reply Susan Melvin |

    I would be confused, too. I think you need to re-check the terms of the auto loan. Particularly look at the section concerning extra payments. Be sure you understand those terms and then call customer service again and this time ask for a supervisor. Who is servicing your loan? Did you get the loan through your bank or credit union, or through the car dealership? The (live) people there might be able to help you more than a customer service agent who can only say prescribed sentences.

    Best case scenario is that they can re-apply all of those extra payments and re-calculate the extra interest you have paid.

    SCM1959

    • Reply Ashley |

      My loan is actually through an online credit union (PenFed). They’ve been really helpful in general, but I d think its a good idea to call back and talk to a supervisor (especially since I don’t really “get” what’s going on)

  • Reply Theresa |

    Yes! Look at the terms of your car loan. How is the interest calculated? Simple interest? Whenever I have paid ahead with car loans they reduce the principal and the loan repayment month moves forward.

  • Reply Joe |

    “Aren’t most loans (cars, mortgage, etc.) arranged so you pay mostly interest up front? Toward the end of the loan terms you end up paying more principal, but initially almost the entire payment goes to interest, right? So basically I’d just be pre-paying mostly interest. Sooo, if that money gets reallocated toward the principal, then there’s a lower balance for the interest to be compounded on (or capitalized on? I’m so confused!). Right? Soooo, shouldn’t my balance go down then??? No?? Why not? I don’t understand!”

    You pretty much have it right here, except as nshells points out above, the loans aren’t “arranged” so that you pay mostly interest up front, that’s just how the math works out. The interest is calculated on the outstanding loan balance which is always greatest at the beginning (we’ll leave “reverse-amortization” loans out of this discussion). Your “payment” is just a pre-calculated amount that lets you neatly pay off all the principal and concomitant interest during the specified loan time-frame. Even though your payment is always the same from month to month, the distribution within that payment of what is going to principal vs interest is slowly shifting.

    If you pay extra on the principal, you reduce the amount of interest that you pay. However, your next “payment” amount doesn’t change, just the distribution of principal vs interest within that payment. And, of course, your payoff date moves up. The reason you would want to pre-pay principal is so that you ultimately end up paying less money on a loan, thus paying it off sooner. This is ultimately what most people want to do.

    The reason why you might want to pre-pay interest, is so that you can stay current on the loan even if you end up with cash flow problems at any point.

    In the case of your auto loan, if everything was communicated correctly and all the extra payments you’ve made so far get converted to “principal-only”, then the person you spoke with is incorrect and your balance should go down.

    • Reply Ashley |

      YES!!!! That’s what I was thinking and why I was so confused! It didn’t make sense to me that the money could be re-allocated but I would end up still having the same balance!? Today is a crazy so I probably won’t have time until mid-week, but I need to call back and make sure everything has been handled correctly and talk to a supervisor about everything. I thought my balance should go down!!!!
      Thanks so much for the comment and clearing this up for me!!!

  • Reply first step |

    You need to look at your loan paperwork to confirm how interest and additional payments are applied. Once you have the loan contract and your list of payments/additional money paid in front of you, you can speak to a customer service rep to see if they will change how the payments were applied, reset your due date and apply the additional money that you paid to principal.

    I make extra mortgage payments each month, and the amount varies depending on the bonus I received for the previous month. I have to set up the extra payments to post after my regular monthly payment, or it will be applied automatically to escrow instead of principal.

    Whenever paying extra on loans, always check your balance and next due date after the payment is posted. Depending on when your payment is due and when you send extra money, the lender may not apply the funds in the way you intended and you’ll need to call in to have the money credited correctly.

  • Reply Connie |

    It all depends on whether your loan is fully amortized. That means that your payments are calculated to pay off the principal in full at the end of the term provided that you make all the payments on time. We’ll assume that is the case. So since you are making extra payments, the loan company is telling you that you have “prepaid” until a certain date. However, if you continue to make extra payments, when you have paid all the principal and enough interest to cover the period it took to pay all the principal, then your loan will be paid in full. You do have to specify on each payment that extra is to be applied to principal.
    There’s a great tool on http://www.bankrate.com/calculators/auto/auto-loan-calculator.aspx that allows you to look at how your loan is broken down and I think you can even put in your extra payments to see how much sooner you’ll be done and how much less interest you will have paid. The basic premise is that you can only be charged interest for the outstanding principal. Since the principal goes down with each payment, that creates the “more interest in the beginning, less at the end” scenario. Look at it this way: if you suddenly had $25,000 and wanted to pay your loan in full, they could only charge you the amount of principal that was unpaid as of the date you make your big payment. When the employee told you your balance was the same, it was probably because the employee doesn’t have a good grasp of how a loan works. But trust and believe, as someone without debt, you always want to pay your loans off early and that is achieved by paying more than the “regular payment” every time you pay. You’re making good progress. Keep up the good work. As an aside, just for some more immediate satisfaction, I think I’d pay off your smallest bill completely instead of focusing on the car so hard. Just my opinion.

  • Reply TENN |

    Car loans are the worst. When I had a car loan, the only way to pay extra towards the principal only (i.e. not on the future payment) was to send a separate check to a different address. Given the small amount of interest, I opted to just keep having them credit it forward. I hated that loan and got rid of it within a year.

So, what do you think ?