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?