Principal payment vs. "Extra" payment?

[Anonymous]

Random question, I've always been confused about this.

Take a typical compound interest loan - a car note for example - with 10% APR and $10,000 current value. Assume the interest compounds monthly (i.e. 10%/12 per month).

On the first payment of $500, the balance is $9500. After interest, it's ~$9579. If you make a second payment in the first month, after interest the balance is ~$9075.

What is the advantage to mark the extra payment as "principal only" payment then? When and where are they useful, and what do they do?

EDIT: spelling error caught over two months later!

[llecs]

When you get any loan, most of your extra payments will be applied to the principal. Certainly read your loan docs to be sure. But making extra payments will certainly cut your interest expense and you'd pay it off much sooner too.

Using your example, I'll assume that your monthly payment is approx. $500. Using your figures as an example, if you have a $10,000 loan at 10%, making close to that $500 at $499.37, you'll pay off the loan in 22 months paying a total interest of $986.15. If you paid $500 extra per month on top of that payment, then your loan term drops from 22 months to 11 months and your interest is also cut nearly in half down to $486.14. BTW, I cheated. Bankrate has calculators to mess around with.

[Anonymous]

---

@llecs wrote:

When you get any loan, most of your extra payments will be applied to the principal. Certainly read your loan docs to be sure. But making extra payments will certainly cut your interest expense and you'd pay it off much sooner too.

Using your example, I'll assume that your monthly payment is approx. $500. Using your figures as an example, if you have a $10,000 loan at 10%, making close to that $500 at $499.37, you'll pay off the loan in 22 months paying a total interest of $986.15. If you paid $500 extra per month on top of that payment, then your loan term drops from 22 months to 11 months and your interest is also cut nearly in half down to $486.14. BTW, I cheated. Bankrate has calculators to mess around with.

---

Right, makes perfect sense. But, doesn't the accrued interest roll into the principal to calculate the next period balance due?

I suppose if a loan was built to where additional payments were only applied to future interest accrual, and thus not credited to the account immediately, that would be the issue... Are such loans common? Is this part of the whole "prepayment penalty" issue?

Thanks for the help. I guess I slept through Finance on this day

[llecs]

The interest is compounded, but rolled into equal installments spread throughout the term of the loan equally. Otherwise, you'd face fluctuating payments. Obviously if you had a $10k loan and make that first payment of $500, the interest starts at $9500 and the total tally was nearly $1000 at 10%. But that compounded interest is spread throughout the loan.

Most all loans are structured where the extra payment applies towards principal vs. the next payment. I don't know how common prepayment penalties are. I had two car notes, a personal loan, and now a mortgage and none of them have a prepayment penalty. Certainly if you refi'd you wouldn't want to be reassessed a penalty for doing so.

Be happy you had a class on finance. Most never had one. IMO, should be a requirement in our grade and high schools.

[Anonymous]

---

@llecs wrote:

Be happy you had a class on finance. Most never had one. IMO, should be a requirement in our grade and high schools.

---

+1 in complete agreement.

The other comments make a lot more sense now, thanks. I hadn't thought about the regular (same) payment piece of it.

[Anonymous]

Absolutely agree about finance classes in high school.  I was researching GM Financial as we selected them to finance our new car recently.  I came across a complaints board where the majority of people were complaining endlessly about how they owed more than originally planned at the end of their loan because they deferred payments.  These people were so angry they were being charged "extra" late fees and were so clueless to the fact that this was interest and that is how interest works.

[OhioCPA]

I see no advantage to marking a payment as principal only, provided you can make payments early.  The disadvantage is that your regular payment is still due the original date.

If your bank allows you to make payments ahead of time I would take advantage of this option instead of making principal only payments. Chase allows me to pay ahead a maximum of ten months, which I plan on doing later this month.

[Revelate]

---

@OhioCPA wrote:

I see no advantage to marking a payment as principal only, provided you can make payments early.  The disadvantage is that your regular payment is still due the original date.

If your bank allows you to make payments ahead of time I would take advantage of this option instead of making principal only payments. Chase allows me to pay ahead a maximum of ten months, which I plan on doing later this month.

---

Unless you're on a simple interest loan, then mathematically paying principal > paying non-zero interest + principal... assuming you can afford the next payment, or unless you don't have some truly funky loan agreement.  I agree for compound interest loans, it makes no difference at all.

Personally given how goofy the economy is and that I now know my current project is over come April, I simply paid out my installment loans so the next isn't due till October on pretty much everything.  If I have to cut back for a few months while being unemployed (though I can't see it's taking more than the six weeks I know ahead of time to find *something* else up to cover my markers in my case)), interest may accrue, but I won't be forced to make a payment or risk late charges.

[Walt_K]

---

@OhioCPA wrote:

I see no advantage to marking a payment as principal only, provided you can make payments early.  The disadvantage is that your regular payment is still due the original date.

If your bank allows you to make payments ahead of time I would take advantage of this option instead of making principal only payments. Chase allows me to pay ahead a maximum of ten months, which I plan on doing later this month.

---

If you're just advancing your payment, aren't you getting no benefit except for the added peace of mind that you don't have a payment due for a while.  In other words, if I have a loan with 24 payments of $500 left, I can pay all 24 payments of $500 right now, but that's likely going to be far more than the current balance on the loan.  No one would do that, of course, but if you're actually trying to pay the loan down faster, you don't want to advance the payments, you want to apply it to principal.  If you want to take cash that you have on hand and make sure you get your loan paid forward so you don't use the cash on something else, that is a different issue.  Am I thinking about this incorrectly? 

[OhioCPA]

---

@Walt_K wrote:

If you're just advancing your payment, aren't you getting no benefit except for the added peace of mind that you don't have a payment due for a while.  In other words, if I have a loan with 24 payments of $500 left, I can pay all 24 payments of $500 right now, but that's likely going to be far more than the current balance on the loan.  No one would do that, of course, but if you're actually trying to pay the loan down faster, you don't want to advance the payments, you want to apply it to principal.  If you want to take cash that you have on hand and make sure you get your loan paid forward so you don't use the cash on something else, that is a different issue.  Am I thinking about this incorrectly? 

---

By paying the payments early you are in effect making additional principal payments and in the process incurring less interest. In your example paying 24 payments today would stop the interest charge on the $12,000 that was paid early.

I financed my car in May last year. In July I paid the next six months payments of $500. This was all credited against principal. When I paid my January payment in January it was all charged against interest since I hadn't made a payment for the last six months as was part of my February payment. The six to ten payments I will pay in the next few weeks will primarily reduce principal, thus lowering my total interest for the year.