Principal payments [closed]

Question

I have had several business loans and understand that this is not by any means typical.

I noticed that for a year my payments were not decreasing the principal on the loan. When I asked the bank why, I found out that at some point my payments were getting applied to principal only. Now I am paying interest off that was not paid for 6 months or so.

My banker states that he can change all the interest payments to principal payments. I am confused to why this would be. If I make all my principal payments first then would the bank lose a substantial amount of interest?

This has happened on 2 of the 3 loans I have looked at so far.

If they are willing to change all the payments to principal only, would this be beneficial to paying less interest ultimately? I assume there would be an interest account accruing somewhere that would need to be paid off at the end of the loan.

I understand that typically you have a loan balance that would include interest and principal. My balance owed did not change when I continued to make same payment? It gets applied to interest. The balance on the statement must not be a true balance. There must be interest owed above the balance showed but why would they do this to start with? They applied full payments to principle only first in order for interest to get to be more than several payments

Answer 1

tl;dr: To answer your specific question, there is no such thing as "principal only" or "principal first" loan. Every payment you make will be applied to accrued interest first, then anything more than that will (usually) be applied to principal. The main payment scenarios are "interest only", or "interest and principal". If you make extra payments beyond the minimum monthly payment, then that amount could be considered "principal only".

Details: Term loans have a set amount of interest and principal that you should pay each month. This is calculated as your minimum payment. Some loans offer an initial time period called "interest only" which means you only have to pay the accrued interest for the month without any additional principal during the time period. The advantage of this is the minimum payment is lower, but the downside is you don't make any headway into paying down the loan. It sounds like your loan was in the interest only period so if you didn't pay more than the minimum payment you wouldn't have lowered your starting balance.

If in any month you paid less than your minimum payment, then that means you didn't even cover the accrued interest so the total amount you owe will increase. Typically if you do this it is considered a late payment and can negatively affect your credit score. However, if you are granted a period of forbearance due to financial hardship, the bank will agree to let you reduce your monthly payment (possibly to $0) until you get back on your feet. It sounds like this is probably what happened in your situation. This is common with student loans after you are done with school and can't afford to make full payments yet.

As for next steps, if your loan is still in "interest only" mode, you can always pay more than the minimum payment each month to ensure you pay down some of the principal. If you can afford it then you could take the lender up on their offer to convert it to a term loan now so that your minimum payment will include principal right away. Even then you can (probably) still overpay any time you wish to lower your total amount due. When you speak to your lender it's a good idea to confirm that any payment amount more than the minimum payment will be applied to principal rather than future payments. Normally that's the default, but not always.

Answer 2

Money is fungible, so it doesn’t matter whether the dollar you pay is labelled principal or interest.

Case 1: interest is calculated on the amount owing.

Suppose you owe $5000 and accrue $50 interest in one period. Your total amount owing is now $5050. If you pay $150, you reduce the amount owing to $4900. You might call it $50 interest + $100 principal or $120 principal + $30 interest etc, but the next round of interest will be calculated based on the same figure: $4900.

Case 2: interest is calculated at the start of the loan and the dollar amount of interest is fixed.

Suppose you borrow $5000 and the terms call for a fixed $1000 interest over the life of the loan. That means you need to repay $6000 all up. I have seen these described as something along the lines of “interest first”. But if you pay $150 one period, you’re reducing the amount remaining to be paid from $6000 to $5850 regardless of whether you label that $150 principal or interest or some combination thereof.

So the label doesn’t affect how quickly the loan is discharged - you’re just working on repaying the loan in either case.

The label matters when it comes to tax. If you can deduct interest payments or if the lender must pay tax on interest received, but capital paid or returned isn’t taxable, the label affects the timing of the tax effect.

For example, if you called your initial payments “interest”, you might be able to claim a deduction early on, but the lender will need to pay more tax early on. If you called it principal, the tax effects might be deferred to a later year.

You also ask in comments about why the balance remains the same even though you continue to make payments. Here’s one possibility: you only paid the interest generated since the last statement. For example, if the balance was $120,000 and the monthly interest was $500, the accrued balance at the next statement should be $120,500. But if you pay $500, it drops the balance back to $120,000. It would look like the balance is unchanged - it was $120,000 on the previous statement and after payment is still $120,000. That’s just because the payment exactly matched the interest for that month.

There may be other reasons for payments not appearing to reduce the balance, but working through the specific details should be done with an appropriate professional such as an accountant who can privately examine the financial records with you.

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Disclaimer: I am not qualified as either a financial advisor or lawyer, and this answer is not to be relied on as financial or legal advice. Please seek professional advice as appropriate.