Does Paying Down Principal Lower Interest?
Understand how extra principal payments can lower your total interest paid and shorten your loan's duration.
Understanding the difference between principal and interest is important when taking out a loan. The principal is the original amount borrowed from a lender. Interest is the cost charged by the lender for borrowing that principal. This article explores how payments toward the principal can directly influence the total interest paid over a loan’s life.
How Loan Interest Accrues
Loan interest accrues based on the outstanding principal balance. The amount of interest charged for a period is calculated as a percentage of the remaining loan amount. For example, if you have a loan with a 5% interest rate and an outstanding principal of $10,000, the interest for that period would be based on that $10,000.
As payments are made on an amortizing loan, a portion of each payment goes towards reducing the principal balance, and another portion covers the accrued interest. In the initial stages of many loans, a larger percentage of the payment is allocated to interest, with a smaller amount reducing the principal. Over time, as the principal balance decreases, a greater share of each subsequent payment is applied to the principal.
This calculation method ensures that the interest paid accurately reflects the amount of money still owed. Lenders commonly calculate interest daily or monthly on the unpaid balance. As the principal balance declines, the base on which interest is calculated also diminishes, leading to potential savings.
Reducing Your Interest with Principal Payments
Making payments towards your loan’s principal balance can reduce the amount of interest you pay. When an additional payment is applied directly to the principal, it lowers the outstanding balance of your loan. Since interest is calculated on this remaining balance, a reduced principal means less interest will accrue.
For instance, if your loan balance drops from $10,000 to $9,500 due to an extra principal payment, the next interest calculation will be based on $9,500, not $10,000. This results in a lower interest charge for that period. This effect compounds over the loan’s life, as each subsequent interest calculation uses an even lower principal balance.
This principle applies whether the principal reduction comes from the scheduled principal portion of your regular payment or from an additional, voluntary payment. Any amount that reduces the principal balance directly shrinks the pool on which interest is charged. It is prudent to confirm with your lender that any extra funds are applied to the principal, rather than simply prepaying future scheduled payments.
Impact on Loan Term and Total Cost
Consistently making additional payments towards your principal balance has two long-term benefits. First, it shortens the overall term of your loan. By accelerating the rate at which the principal is paid down, you reduce the number of scheduled payments required to fully repay the debt.
Secondly, this strategy leads to savings on the total interest paid over the loan’s life. Because the principal balance is reduced faster, less interest accrues over the remaining term. For example, adding even a small amount like $50 or $100 to your monthly payment can shave years off a 30-year mortgage and save tens of thousands of dollars in interest.
This cumulative effect can be advantageous for borrowers. The earlier in the loan term that extra principal payments are made, the greater the potential interest savings, as those funds stop accruing interest for a longer period. While paying extra principal does not lower your monthly payment amount, it frees up financial resources sooner by eliminating the debt more quickly.