What are Principal Only Payments? Should I Make Them?

If you have outstanding loans, you should know what principal-only payments are. Making payments on the principal balance of your loan could potentially save you a lot of money over time. Not all lenders accept principal-only payments, so it would be wise to look into that option before taking out a loan if possible.  When you use a loan to purchase goods or services, the principal balance is the amount you borrowed, and the interest is what you're paying to borrow that money. The interest is calculated monthly as a percentage of what you owe on the principal balance. A principal-only payment is an additional money you send in that directly brings down the principal of the loan, therefore cutting down the payments on interest. If that sounds confusing, we’ll break it down even further in a minute.  Before we go too far, it’s important to have a strategy in place when making extra payments towards your principal balance. If you’re going to dish out more money than you have to, you might want to make sure it’s being used wisely! Start with the debts that have the highest interest rate because those tend to charge you the most to use their funds. If the debts you’re dealing with have similar interest rates, start with the smallest one first. That way, you’ll have a sense of accomplishment and feel more motivated to keep knocking down those debts.

Benefits of Making Payments on Principal Balance Only 

Anytime you can minimize your debt, it’s going to be beneficial for your finances. The less money you’re paying on unnecessary fees, the more you can put towards your savings or paying down other debts. As you pay down those debts one-by-one, you’ll be improving your credit profile, which also helps you save more money in the long term. As your debt decreases, your debt-to-income ratio improves, so it’ll be easier to qualify for the best loans with the lowest interest rates. The more attractive you are to lenders, the better spot you’ll be in to negotiate terms in your favor. When you pay additional payments directly toward the principal balance, you cut down on the life of the loan, which ends up saving you in interest payments. The faster you pay back borrowed money, the less you have to pay for borrowing it. If you must borrow funds to accomplish your goals, try to pay them back as quickly as possible. 

Loan Principal: How it Works

When you make payments on a personal or business loan, your payment goes towards two balances - the loan principal and the loan interest. Making additional payments on the principal balance will reduce the amount of interest you’ll pay over the life of a loan since the monthly interest amount is calculated on the outstanding loan balance. The interest rate is separate from the annual percentage rate (APR), which is the interest rate plus any other yearly fees. Lenders make their money off of charging you fees and interest, so not all of them allow you to make extra payments towards your principal balance. If possible, ask before you decide on a lender. Some auto loans and mortgages will allow you to make additional payments but charge prepayment penalty fees, so be on the lookout for those in your agreement. If your lender charges exorbitant fees for prepayment, that can defeat the whole purpose of making additional payments.  If you decide to make additional payments, you’ll need to designate those extra funds as principal-only when you pay your bill. Some lenders will want you to write a separate check, and some simply ask you to check a box and enter the extra amount. It’s important to know the policy for your specific lender so it can be counted appropriately. Then, check your statement each month to confirm the money is being allocated to the right place. If your bank doesn’t charge fees for additional payments, you can add whatever amount you want to the regular payment each month. If you get paid bi-weekly, you might choose to take money from each paycheck, so you’re not tempted to spend the money, which will help get those debts paid down as quickly as possible. If you receive an inheritance or a tax refund, that’s a great time to put a lump sum of money toward the principal balance.  

Things to Consider 

Before you start making extra payments on one of your debts, you should come up with a strategy. These days, it’s common to have several credit cards, a car loan, student loans, a mortgage, and maybe even a few personal loans. If you have extra cash to put towards your debt, start by focusing on one at a time. It’ll be easier to stay on track, and you’re likely to see results faster.  When choosing which one to start with, take a look at the interest rates for all of them. Start with the loans you pay the highest interest on. Your money will go further towards your financial goals if you eliminate the accounts that have the biggest fees. If all of your debts have similar interest rates, start by knocking out the one with the smallest balance first.  Avoid loans that charge prepayment fees altogether if you can. Lenders and dealers do not always offer you the best rates available at first. Don’t be afraid to negotiate - you can save yourself a lot of money over the life of the loan if you insist on getting the best interest rate and lowest APR available.  The Consumer Financial Protection Bureau (CFPB) is a U.S. government agency that regulates banks, lenders, and other financial institutions to make sure they treat you fairly. According to them, all student loan borrowers have the right to make additional payments without being penalized or paying fees. Of course, student loans typically have lower interest rates than other common debts, so remember to strategize which debts you should pay off first. It’s always best to start with the best loan terms possible. Don’t commit to anything you haven’t fully looked over. Make sure you don’t overextend yourself and wind up putting yourself in a bad financial situation. If you can make extra payments consistently, you’ll pay your loan off quicker and have the option to allocate your funds to where they’re needed most. 

Let’s Recap: 

If you want to pay down your loan as quickly as possible, making additional payments toward the principal balance is important. Even just one extra payment a year can make a big difference in the long term . The interest fees are calculated by the principal balance, so the lower you can get it, the less you’ll be paying in costly fees. Not everyone has extra funds just lying around at their disposal. If your goal is to save as much money as possible, you’ll need to go into it with a strategy. Check the interest rates on all of your loans, and start with the one that has the highest rate and/or the smallest balance. Either way, focus on one at a time, and you’ll get addicted to the feeling of accomplishment as you start scratching them off your list.  If you are lucky enough to be gifted a big sum of money or receive a large tax refund check, you should consider putting a chunk of it towards your debt. Minimizing your debts will help you in a variety of ways. As you pay down those loans, you will better your debt-to-income ratio. Having a well-balanced debt-to-income ratio will increase your credit score, which helps you get better terms on any future loans. It may seem tough at the beginning of this cycle, but it’ll feel great when you know you’re saving a lot of money on unnecessary fees. Next time you’re shopping for an auto loan or a mortgage, pay close attention to the fine print. If possible, try to avoid loans that have penalties for paying additional payments on the principal balance. Luckily, federal student loan lenders aren’t allowed to penalize you for paying them off early, as it is the second-largest debt Americans have. Paying off any of your debts early is a good idea, but student loans often have the lowest rates, so they often get pushed down the totem pole of priorities.  The key takeaway is, do what makes the most sense for your financial situation. If you’re able to put some extra cash towards your principal balance, do it. The less you’re paying interest fees each month, the more you can save for retirement or put towards the dream vacation you’ve always wanted to take! Sources: https://www.daveramsey.com/blog/the-secret-to-saving-money https://www.consumerfinance.gov/ask-cfpb/what-is-the-difference-between-an-interest-rate-and-the-annual-percentage-rate-apr-in-an-auto-loan-en-733/ https://www.usnews.com/education/blogs/student-loan-ranger/articles/principal-only-student-loan-payments-what-to-know