Everyone wants to get out of debt as quickly as possible. Some folks play the lottery every day, dreaming of that big jackpot. Others choose a more sensible approach. They use a loan payment calculator, review their budget, and figure out how to increase monthly payments to shorten their loan term. It’s a good strategy if the borrower does it correctly.
Begin with a budget analysis
Major corporations cut costs and eliminate debt by doing a budget analysis. Individuals can do the same thing. Income and expenses should be listed and analyzed before attempting to make “extra” payments on loans. That money must come from somewhere. Paying more on a loan each month means taking funds away from something else.
The key is separating expenses into “essential” and “non-essential” categories. Items like mortgage and rent payments, utilities, and food are essential expenses. Premium movie channels and unused gym memberships are not. Eliminating those, even if they’re only a few dollars a piece, frees up money to make extra payments on your loan.
Pay on principal, not interest
Where the payment goes is as important as how much the borrower pays. Lenders use an amortization schedule on loans and mortgages that allocates a certain amount of every payment to interest. In the early stages of the loan term, the interest portion is much higher than the principal portion. Borrowers want extra payments to go to the principal.
Lenders differ on this. Some will allow the borrower to select “pay on principle” when they make an extra payment on their loan. Others simply apply it to interest. To avoid this, make the extra payment at the same time as the regular monthly installment payment. The interest portion won’t change, but the amount applied to the principal will be higher.
This is particularly important when making mortgage payments. There should be an option to pay strictly principal, which increases the amount of equity the borrower holds in the home. It’s rare to find a mortgage broker or bank that doesn’t allow this. Homes are a major purchase, and home buyers have leverage over lenders because they’re long-term customers.
Watch out for early repayment penalties
Lenders charge an annual percentage rate (APR) on loans, including interest and fees. They don’t really profit from the interest because it covers what they pay other banks to borrow money. The fees are where they make their money. If a borrower pays their loan off early, any monthly fees the lender profits on will be eliminated. They may charge for that.
Read the loan agreement carefully to see if there are any early repayment fees. Making extra payments might cost the borrower a “balloon payment” at the end of the loan term. That payment might offset any savings incurred while making those extra loan payments. It seems unfair, but the sad truth is that some lenders operate this way.
The Bottom Line
Extra payments are usually a good thing. In most cases, making extra payments on a loan is a good thing if those payments are applied to the principal. When a lender won’t do that, add the extra payment to the regular monthly installment payment. If there’s an early repayment fee, do the math to see if there’s still savings involved for making extra payments. Most of the time, there will be.