What Increases a Total Loan Balance?
Explore the underlying reasons why your total loan balance might increase, even when you're making payments. Gain financial insight.
Loan balances are typically expected to decrease with each payment. However, various factors can cause the total amount owed on a loan to increase. Understanding these mechanisms is important for managing debt and avoiding a growing loan balance. This outcome arises from how interest is calculated, the application of fees, specific loan structures, and certain financial events.
The Role of Interest
Interest represents the cost of borrowing money and begins to accumulate from the moment loan funds are disbursed. Lenders calculate accrued interest based on the loan’s principal balance, the interest rate, and the time elapsed since the last payment. This interest accrues daily, even if payments are made monthly or quarterly.
When a payment is made, it is typically applied first to cover any outstanding accrued interest before any remaining amount reduces the principal balance. If a payment is less than the interest accrued since the previous payment, the unpaid portion is added to the principal balance. This process, known as capitalization of interest, means the borrower pays interest on interest.
Fees and Other Charges
Beyond interest, various fees and charges can be added to a loan’s outstanding principal balance, increasing the total amount owed. These may include late payment fees or returned payment fees. Origination fees, charged for processing and underwriting a loan, can range from 1% to 10% of the loan amount and may be added to the principal rather than deducted from the loan proceeds.
Other charges, such as administrative fees or penalties for specific loan term violations, can also be capitalized. When these fees are not paid separately and are instead added to the principal, the borrower begins to incur interest on these charges. This increases the overall cost of the loan and can extend the repayment period.
Loan Structures Causing Principal Growth
Certain loan agreements are designed to inherently lead to an increase in the principal balance, even with regular payments. One such structure is a negative amortization loan, where scheduled monthly payments are intentionally set lower than the interest accruing each period. The unpaid interest is then added to the principal balance. This can result in the borrower owing more than the original loan amount, despite making consistent payments.
Another type is a deferred interest loan, commonly found in consumer financing for purchases like appliances or retail credit cards. With these loans, interest accrues from the outset but is not charged if the entire balance is paid off by a specified promotional date. However, if the balance is not fully repaid by this deadline, all accrued interest, often backdated to the original purchase, is added to the principal balance.
Events Leading to Increased Principal
Specific events or actions can also cause a loan’s total balance to increase, distinct from routine interest accrual or inherent loan structures. The capitalization of unpaid interest or fees is common after periods of forbearance or during a loan modification.
Forbearance allows borrowers to temporarily suspend or reduce payments, but interest typically continues to accrue, and this accrued interest can be added to the principal balance at the end of the forbearance period. Similarly, during a loan modification designed to make payments more manageable, past due amounts, including missed payments and accrued interest, can be rolled into the new principal balance. This increases the total amount owed, although it may reduce the immediate monthly payment.
For mortgage loans, an escrow shortage can also lead to an increased loan balance. This occurs when property taxes or insurance premiums increase, and the lender covers the shortfall from the escrow account, then adds that deficit to the outstanding mortgage principal.