Key takeaways:
- The principal of a loan is the original loan balance you agree to pay back before interest is calculated.
- Some borrowers can make extra principal-only payments to help pay down their loan faster. This may help save money on interest over time.
- Principal payments are best for borrowers with extra money and no other high-interest debt.
When you take out a new loan to achieve a financial goal, the last thing you want is to spend more on interest than you have to. To streamline paying off your debt, and potentially save on the cost of the loan, you may want to consider making extra principal-only payments.
Read on to discover how principal-only payments work, the benefits, and what to consider before you make an extra payment.
Principal payment definition
A principal payment only lowers the principal balance of a loan.
Making principal-only payments is a financial strategy you can use to pay down your loan faster. When you make a principal-only payment, your money only goes toward the principal balance. It does not pay down any accumulated interest.
How a principal payment works
When you take out a loan, the monthly payments you make consist of both the principal and interest amounts.
- The principal is the sum of money you borrowed from the lender. It’s the debt you owe and agree to pay back in a fixed amount of time.
- The interest is the cost of taking out the loan. A lender determines loan interest as a percentage of the principal amount. This is typically based on a variety of factors, including your annual income, credit score, credit history, and current debt.
Your ongoing minimum payments will likely be applied to fees and interest first. Then, the remainder of your payment will go toward the loan principal.
However, if your lender allows it, you can apply an additional principal-only payment to your balance. It’s specifically used to pay down your principal amount without any other loan cost factored in.
Pro tip: Not all lenders allow principal payments, and some that do will charge extra fees. Before deciding to make a payment on your principal, consult your lender to learn more about your options.
Regular payment vs. principal payment
First, you must make a regular payment on your loan before you can make a principal-only payment.
Regular payments include fees, interest, and a payment made on the principal balance of your loan.
After you make your regular payment, you can then apply principal payments. Any principal-only payment on a loan is considered an additional payoff on the balance. Because the interest is based on the total principal, your interest paid lowers as your loan principal is reduced.
Pro Tip: It’s important to check that your principal-only payments are being applied correctly. After you make a payment, review your statement to ensure your payment was applied to the principal and not interest.
Benefits of making principal-only payments
There are a couple of reasons why making one, or several, principal-only payments can be a good financial move. The benefits of making principal-only payments include:
- You can pay off your loan faster: By making additional payments toward the loan principal, you can shorten the length of your repayment term.
- You can save on interest: Paying down your principal faster can help lower the total amount of interest you pay on your loan. That’s because the more you pay down your balance, the less interest will accrue.
What is a principal payment example?
Let’s say you took out a personal loan for $30,000 at an interest rate of 5% to pay back over the course of 6 years. With $4,786.65 in interest fees, your total owed will be $34,786.65.
When you start making regular monthly payments, you also decide to make an additional principal payment of $250 every month. With each additional payment, you reduce the principal balance of the loan. Because your interest payment is based on the principal balance, your remaining interest amount will be reduced as well.
In this scenario, you’d be saving $1,826.87 because you cut the total interest down to $2,959.78 by paying extra to the principal each month.
Questions to consider before making principal payments
Principal payments seem like a profitable decision. However, when it comes to finances, you should always make sure you understand exactly what you’re committing to. Below are a couple of important factors to keep in mind.
Do large principal payments reduce monthly payments?
No. For most loans, principal payments will not reduce the monthly payment amount you owe. However, contributing more than your monthly loan payment will reduce the loan balance quicker. This may help you save money in interest over the life of the loan.
Does your lender allow principal-only payments on loans?
Some lenders don’t allow principal-only payments. Others will allow these types of payments but charge a fee, such as a prepayment penalty.
The fee amount and how it’s applied can differ by lender, and it could defeat the purpose of making a principal-only payment. That’s why it’s crucial to read the loan contract carefully and speak to your lender before making any principal payments.
Do you have other high-interest debt?
If you have multiple loans, consider prioritizing the one with the highest interest. For example, you may want to focus on paying down high-interest credit card debt first. Doing so may save you more on interest overall.
You might also consider using a debt consolidation loan to combine all your debts into one monthly payment.
Pro Tip: If you’re struggling to pay high-interest debt, consider the advice of experts and seek out a debt management plan.
Do you have funds set aside for an emergency?
As a general rule, it’s important to set aside three to six months’ worth of living expenses in savings in case you lose your job or an emergency expense comes up.
If you don’t have an emergency fund or your savings account is running low, consider building up your reserves before you start making principal payments.
Without financial reserves in place, your loan and all the extra principal payments you contribute could be at risk should something unexpected happen.
The bottom line: Are principal payments suitable for your financial situation?
Principal payments can be beneficial for some borrowers, but you should only make principal-only payments if you can comfortably afford it. Consider the advantages of a principal-only payment for your current financial situation, looking at your savings, income, and any additional debt you have.
When in doubt, talk to your lender before committing to a principal-only payment to ensure you understand the terms and conditions.
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