Principal-Only Payment!?
April 4, 2016 7:56 PM   Subscribe

I intend to pay extra towards my car loan this month and I think it's to my advantage to make a principal-only payment. But I don't understand why that's a particular kind of payment, given that the interest accrues interest, right?

I emailed the credit union to ask and they said:
Any regular payments above your monthly payment amount will be applied towards future due dates.

Interest accrues daily on installment loans and is paid first when a payment is received. The remainder of the payment is applied to other charges (if applicable) and then to the principal balance of the loan.
For the sake of argument, assume I owe $1000 at an APR of 1% to be paid over a year. So I'd owe $1010.05 after a year and (I think) my payment would be $84.17/month. I send them $100 after 30 days. With interest, the balance on the loan is 1000.82. So 82 cents goes to interest, leaving $99.18. Does that all go to the principal (which is what the second paragraph means to me)? Or does $83.35 go to the principal and $15.83 end up in limbo somewhere (which is what the first paragraph implies)?
posted by hoyland to Work & Money (12 answers total) 1 user marked this as a favorite
Making a principal-only payment decreases the interest you'll have over the life of the loan. Some banks make you make one "regular" payment, then you can make another "principal only" payment later.

I'm not understanding the numbers as you have laid them out, but I have done this many times (over a lot of car loans) and it is the way to go. Make one regular payment, make one principal only payment, even if it's just the next month's principal if it's all you can afford.
posted by getawaysticks at 8:18 PM on April 4, 2016

For your loan, there's no difference between principal-only and just paying extra.

There are situations such as some(all?) mortgages where an extra payment would be held in escrow until the next due date, costing you more interest. But your car loan simply accrues interest daily based on whatever principal is available and your payment goes straight to the loan's account at the CU.

When you make your extra payment, check the transaction log in online banking to see how it is distributed. You'll be happy with it.
posted by michaelh at 8:25 PM on April 4, 2016 [1 favorite]

Multiple times now I have run into loans where they put any extra payments towards future INTEREST instead of principal. It's disgusting. So I would recommend you send in your extra and write a note on it saying "please apply this payment to my principal." And then I'd call up and make sure it happened.
posted by small_ruminant at 10:23 PM on April 4, 2016 [4 favorites]

Based on what you have written out there, and my experiences:

If you pay $100 now, your monthly payment of $84.17 is taken from that. The remaining $15.83 is saved and applied to your next month's bill, so that next month they will tell you that you only owe them $68.34. If you only paid that $68.34, the following month your bill would be $84.17 again. This method charges you interest as if you had not paid any extra, though there are some other potential benefits.

If you pay $84.17 now, and then make a principal-only payment of $15.83, the bank then recalculates all future monthly payments to account for a (very slightly) smaller amount of interest accruing. If you want to minimize the total amount of money paid over the life of the loan, while keeping the loan period the same, this is the better choice.
posted by Night_owl at 10:36 PM on April 4, 2016 [4 favorites]

I'm guessing the kind of loan you have is like where the sooner you pay off the principal, the less interest you'll end up paying overall. This means if you pay off your current principal amount today, you're one and done and the bank doesn't get any further interest from you, whereas if you only make monthly payments, you'll end up incurring hundreds to thousands of dollars in interest over the years. If so, a good strategy is to pay off as much of the principal you can as soon as you can.

Any regular payments above your monthly payment amount will be applied towards future due dates. If you make payments in excess or in addition to your regular due payment, that extra amount will be applied towards your next payment. This means if you pay double your due amount, you will cover this month's and next month's payment.

It's better to apply that extra money towards principal-only payments
(assuming you have a steady stream of income) because you will pay off your loan sooner and thus end up paying less interest overall. When you make payments in advance rather than towards principal, all you're doing is paying off that extra interest amount sooner, meaning giving free money to the bank sooner. Which is great for them but makes no difference to you if you pay next month today or pay it next month.

When you apply that to the principal instead, your overall interest paid will be lower in the end. Your monthly due amounts may not go down, but your overall interest paid will. Essentially every time you chip away at the principal as opposed to future payment, you're saving yourself some money that would have gone to interest at the end of your loan.

You may need to specify to your bank how you want your extra amounts or extra payments to be applied if you want to do principal-only rather than future payment. It's not surprising that they would choose to automatically apply exces payments for future payments because this keeps you in debt and accruing interest longer.

Interest accrues daily on installment loans and is paid first when a payment is received. The remainder of the payment is applied to other charges (if applicable) and then to the principal balance of the loan.
This means paying off interest is the bank's priority rather than the principal sum. Why? They want to keep you in as much debt as possible. Say you make a payment that's only a portion of the due payment. They'll apply what they can to the interest amount first because the larger your principal stays, the more interest they can charge you overall and the more $ you will give them in the end. If they apply it to the principal, they have less to charge you interest on.
posted by atinna at 10:36 PM on April 4, 2016 [4 favorites]

the bank then recalculates all future monthly payments to account for a (very slightly) smaller amount of interest accruing.

This is not true on most car loans. I pay slightly more than the calculated monthly payment of my car loan (I round up to the nearest multiple of $50) and my payment hasn't gone down. On the other hand, I expect I'll pay off the car a few months sooner than I would have if I made the calculated payment.
posted by madcaptenor at 10:17 AM on April 5, 2016

Yes, the payment stays the same and the mix of interest and principal changes.

Night_owl, on these loans you don't have to choose between pushing back the due date and paying extra on principal. Both happen.
posted by michaelh at 10:47 AM on April 5, 2016

Don't assume this. I had a car loan where I was making extra payments, thinking it was going toward the principal, because that's how my mortgage worked. Later I found out they were just applying the extra payments toward future payments (including interest), and I ended up with no payments due for something like six months. That makes no sense. The point of interest is to be collected for the time when the principal is not paid, so if I make payments earlier than required, logic would dictate that I would owe less interest. Banks and credit unions rarely follow such logic. You would have to contact the bank/CU beforehand, and tell them you are doing this, and I'd also include a note with the payment to apply it to decreasing the principal, then follow up to make sure they did this.

Banks and credit unions make money off of interest, so it is in their interest (ha!) to collect as much interest from you as possible. Hence, they don't make it easy to make an advance principal payment.
posted by tckma at 11:18 AM on April 5, 2016

The answers to your questions are yes and no, respectively, although some of your numbers in your example are off a bit, and you're misunderstanding the meaning of the first paragraph of your credit union's response.

Using your example, assuming that your loan is scheduled for twelve equal monthly installments, and using 30-day months for simplicity, your monthly payments would be about $83.78. You calculated the first months' interest of $0.82 correctly, which would leave $82.96 out of the regular $83.78 payment to be applied to principal, resulting in a new balance of $917.04. This is the balance on which interest accrues until your next payment. When you make your payment 30 days later, $0.75 in interest will have accrued, so $83.03 goes to principal, with a new balance of $834.02. This will continue until your final payment of $83.77, with $0.07 to interest and $83.70 to principal. Your payments will have totaled $1,005.35, and your total interest will be $5.35, not $10.05.

If you pay $100 on the due date each month, the first month's payment will put $0.82 to interest, and $99.18 to principal, as you noted. Your new balance will be $900.82, so 30 days later, only $0.74 in interest will have accrued, and $99.26 will go to principal. If you continue paying $100 each month, you will make 10 payments of $100, and an eleventh payment of $4.55. You will have saved $0.80 in interest, and your loan will be paid off a month early. That is the advantage of making extra payments to principal.

The first paragraph in your credit union's response is about how your loan's due date is advanced, not about how payments are applied to principal and interest. They're just saying that if you pay extra this month, you can pay that much less next month, and your loan will not be delinquent.

If you're worried whether the extra amount you've paid went to reducing your principal, check your transaction receipt (if you pay in person), or your online banking, or your paper statement. It should show you how much of your payment went to interest and how much to principal.
posted by ogooglebar at 12:47 PM on April 5, 2016

I'm inclined to believe ogooglebar because they caught the goof with the interest. On the other hand, I suspect tckma is right that the additional money won't go to the principal--if it did, why would there be instructions for making a principal-only payment? (I probably should have mentioned that there are explicit instructions for doing so.) I should probably make a principal-only payment and send an extra $5 along with the regular payment and then inspect the statement to figure out what happened.
posted by hoyland at 7:25 PM on April 5, 2016 [1 favorite]

Your credit union has explicit instructions for a principal-only payment because "principal-only" has a specific meaning that is different from what you described in your example. A principal-only payment is one where you're instructing the lender to apply the entire amount of the payment directly to principal, with none of it going to interest. In practice (as described in the second paragraph of their response), any extra amount that you send in at the same time as your regular payment is a "principal-only" payment, because you've already covered all of the accrued interest.

If this is confusing, consider this example: suppose your payment is due on the 30th of the month, and you always pay the full amount of your scheduled payment on the 15th. One month on the 20th, you've already paid the regular payment on the 15th, but you find you have an extra $25, and you want to make an additional loan payment. If you pay the $25 with no special instructions, the credit union will take the accrued interest (5 days' worth) off the top of the $25, and apply the remainder to principal. However, if you tell them that the $25 is to be principal-only, they will apply the entire $25 to principal, and collect the accrued interest when you make your next regular payment. This is to your benefit, because the interest that accrues after the 20th is accruing on a lower principal balance than if you hadn't specified "principal-only."

Note that in this example, if you include the $25 with your regular payment on the 15th instead of waiting until the 20th, the entire $25 will go to principal whether or not you instruct the credit union to do so, because your regular payment has already covered the accrued interest.
posted by ogooglebar at 9:36 PM on April 6, 2016

Have you googled "loan amortization"? If you understand it sorry for doubting you, else please do.
posted by Pembquist at 11:37 PM on April 6, 2016

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