Is It Better to Make a Principal-Only Payment?

A loan payment generally consists of two primary components: principal and interest. The principal refers to the original amount of money borrowed, while interest is the cost charged by the lender for the use of that money. When you make a regular loan payment, a portion of that payment reduces your outstanding principal balance, and another portion covers the accrued interest. An “additional principal payment” is an amount paid over and above your scheduled regular payment, specifically designated to reduce only the principal balance of your loan.

Understanding Loan Payments

Early in the life of many long-term loans, a larger portion of each payment typically goes towards interest, with a smaller amount applied to the principal. This allocation shifts over time through a process called amortization. As the loan matures, the interest portion of your payment decreases, and a progressively larger share is directed toward reducing the principal balance. This structured repayment ensures the loan is fully paid off by the end of its term, but it means that in the initial years, your principal balance may decrease slowly.

The Impact of Additional Principal Payments

Making additional payments specifically to the principal can significantly alter the trajectory of your loan repayment. When you pay extra and direct it solely to the principal, that money immediately reduces the outstanding loan balance. Since interest is calculated on the remaining principal amount, lowering the principal directly reduces the amount of interest that accrues over the life of the loan.

For example, consider a hypothetical $200,000, 30-year fixed-rate mortgage with an interest rate of 6.66%. A regular payment would involve a specific amount of interest and principal each month. If you were to add an extra $100 to your monthly payment, specifically earmarked for principal, it could potentially shorten the loan term by several years and save tens of thousands of dollars in total interest paid. Similarly, a larger additional payment, such as an extra $200 per month on the same loan, could cut the loan term by over eight years and reduce interest costs by over $44,000. This direct reduction of the principal balance accelerates the amortization process, allowing you to pay off the loan faster and incur less interest over time.

Key Considerations for Principal Payments

Before committing to additional principal payments, it is prudent to evaluate your overall financial health. A foundational step involves ensuring you have a robust emergency fund, covering three to six months of essential living expenses. This fund provides a financial safety net for unexpected costs, preventing the need to incur new debt or disrupt your financial plans.

Prioritizing higher-interest debt is another important consideration. Credit cards, for instance, often carry high annual percentage rates (APRs). Paying down such high-interest obligations first can lead to greater interest savings than making extra payments on a lower-interest loan, like a mortgage. Also, assess whether investing additional funds might yield a higher return than the interest rate on your loan. If your loan’s interest rate is relatively low, allocating extra money to investments could potentially generate more wealth in the long term.

How to Make Principal Payments

Making an additional payment solely to the principal requires specific action to ensure the funds are applied correctly. It is important to communicate clearly with your lender that any extra money beyond your regular payment should be applied directly to the principal balance, not towards future interest or to simply “advance” your next payment due date. Without this specific instruction, lenders might automatically apply extra funds to interest or hold them as part of your next scheduled payment, which would not provide the same benefits.

Many lenders offer various methods for making these types of payments:

• You can often specify a principal-only payment through online banking portals, where there may be a dedicated option or a section to add an “other amount” with instructions for principal application.
• Alternatively, some lenders may accept additional principal payments via mail, sometimes requiring a written note with the check.
• Over the phone, where you would verbally confirm your intent with a representative.

After making an additional principal payment, it is advisable to verify through your loan statements or online account that the funds were indeed applied as intended, directly reducing your principal balance.