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Some people say that in order to pay off a loan sooner, you should ask the lender to "apply your payment towards the principal", so that they won't "apply your payment towards the interest".

From my understanding, most lenders don't separately track "interest owed" and "principal owed" - they just track the total amount you owe. Even if they did, it wouldn't make a difference whether you paid down the interest account or the principal account, because the total amount you owe (and the total amount of interest you'll have to pay on it) will still be the same.

Why do people say to make sure your payments are applied towards the principal?

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    I have never understood this one. If you don't pay enough interest you'll have a late payment which is a bad thing. If you've paid the interest all that's left is principal, what else could they pay it towards? I've sent extra money without instructions, it's always been applied to the principal and reduced the loan term. (They don't send you a recalculation, though.) – Loren Pechtel May 29 '16 at 22:13
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    @LorenPechtel They could apply it towards the next scheduled payment. If I had to pay $1,000/month due on the first and they received a $1,000 payment from me on the 15th, they could either consider it an extra payment and count it towards principal or they could consider it next month's payment early. How do they know which way I intend it? (And it makes a difference, doesn't it?) – David Schwartz May 30 '16 at 20:15
  • @DavidSchwartz If the bank chooses to apply the out-of-schedule payment to the next scheduled payment, is the borrower given any credit for that amount before the scheduled payment date arrives? I.e. does the bank include that amount in interest calculations immediately, or not until the scheduled payment date? – atkins May 31 '16 at 11:38
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    @atkins It depends on the terms of the loan. But the key issue is when the bank is expecting the next payment. (Ideally, you could make payments in any amount at any time, and they'd pay down the total. And a payment would only be due/overdue if you fell behind the original schedule. But few loans are actually that flexible.) – David Schwartz May 31 '16 at 12:11
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Many lenders in the US do permit additional payments to be made against the principal. Those will reduce how much you actually owe, which reduces the total interest you will owe over the duration of the loan as well as shortening its duration. It is not uncommon for people to take a 30 year mortgage so they have the option of paying slowly, but to make the additional payments to shorten it to 20 or 15 years... at a total cost not too much more than the shorter loan would have cost.

Not all lenders/loans will let you do this. If yours doesn't, your only option to reduce total cost of the loan is to refinance.

Note that you may need to explicitly say you want the extra applied to principal, or they may count it as just prepaying future installment payments the loan.

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    The last sentence answers my question. – not_a_comcast_employee May 29 '16 at 9:10
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    Why do lenders give a choice here? This seems to be a "trick" to save money. It doesn't seem to have any downside to the borrower. Some borrowers will randomly pay a higher or lower total amount depending on whether they happen to know the "trick". – boot4life May 29 '16 at 14:49
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    @boot4life A borrower might actually want to pay their regular payment early, if it is more convenient for him. Interest needs to be paid every month. If you send in an early payment, intending it to be your next regular payment, but the bank guesses wrong and applies it to principal-only, they will still be expecting a regular principal-and-interest payment at the end of the month. – Ben Miller May 29 '16 at 15:59
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    Not all loans are paid by direct deposit, even now. Don't assume that you know what they will assume -- ask. – keshlam May 30 '16 at 21:12
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    I'll just throw another angle in - speaking for Australia anyway - interest payments may be tax deductible on a rental property, but principal payments are certainly not. In this case is is usually advisable to have an interest-only loan and not over pay it at all. An offset account can help store excess money in a tax-efficient way. There is much more to this and books have been written on the topic about how best to structure loans for investment. – Martin Capodici May 30 '16 at 23:35
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It is extra payments that you apply to the principal.

Here is an example. Let's say that you have a mortgage with a monthly payment of $1000 per month (principal and interest), which you pay on the 1st of the month. Now, let's say that, in addition to your $1000 regular payment, you have an extra $1000 that you would like to pay to reduce your debt. So after you pay your regular payment on July 1, you send in your extra $1000 on July 10. The question is, how will the bank apply this payment? They could treat it like an early payment of your August principal and interest payment, but that is not really what you want, as you are intending to still pay your August payment on August 1. Instead, you want the entire $1000 to be applied to the principal only. Then, because your principal has been reduced, your accumulated interest will be a less, and when your August payment is processed, less of it will be for interest, and more of it will be for principal. Ultimately, your mortgage will be paid off early, saving you money.

The way that banks process extra payments will be dependent on the individual bank's policy. However, without you telling them what you want to do, they are left to guess what your intent is. By explicitly telling them that you want the extra payment applied to principal only, you are ensuring that the extra payment is credited the way you want.

  • It is extra payments that you apply to the principal. Maybe. That is, our monthly mortgage payment coupons provide three check boxes to select where any amount above the scheduled amount should go. The three choices are principal, interest or escrow. IOW, the extra isn't necessarily for principal, though I've never looked into why I'd select interest nor what any long- or short-term difference would be. – user2338816 May 30 '16 at 5:33
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    @user2338816 Presumably, going by comments above, you might select Interest if you were pre-paying the following month's installment (say, because you weren't going to be around to do so at the due date). – TripeHound May 31 '16 at 9:05
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No, it's not a placebo it's an important decision and one that you should make EVERY SINGLE TIME you pay extra.

Let's say you have a loan your $1,000. You have agreed to make payments on principal and interest for 11 months, paying back a total of $1100 principal and interest.

Now you start to pay, and you decide you want to pay this off early, so you pay $110 a month. In month 3 you pay $500.

If the payments are applied to principal first, your high interest rate is on a smaller principal. So you end up paying a smaller total. This is even more important if your interest is compounded daily or monthly (more frequently). In this example you would pay off your loan in about 9 months, with the last payment being pretty small. This would save you about $40 in this example.

If you don't check the box and you let the bank apply the payment to future payments, it will still take 11 months to pay off the loan, and you will still pay the full interest of $100. What happens is that your extra $10 is just going to next months payments, no different then paying your phone bill. That time you paid $500 you just paid the next 5 months. In the end you still end up paying for all 11 months, it's just the bank holds on to it for you, then applies it.

This difference is important depending on your goals. In month 3 (when you paid $500); In the first example, you would still owe $100 in month 4. In the second example you would not owe any money in month 4 (as a payment). Making payments early can be used as a buffer to cover for "hard times". Paying extra, can not. You will still owe the next months payment, and you will still default if you don't pay it.

Important notes:

  • Numbers here are fake. There just an example.
  • Banks are required to track principal, interest, and other categories seperatly. When trying to foreclose or other actions, they have different rules around how they can collect what parts of the money owed. Specially true if insurance is involved in any way (like a insurance payout).
  • It can some times be good to pay for months in advance. For example going on vacation, you may want to pay for next month's payment because you won't be around to mail it in.
  • Usually though if your trying to pay extra, your going to want it to go to principal.
  • If you want a "hard times" buffer you usually better off getting a seperate checking account and storing money there, with the loan auto drafting from it, then making early payments.
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    So the short answer is "it's not paying principal vs paying interest, it's paying principal vs pre-paying next month's payment". – not_a_comcast_employee May 29 '16 at 8:49
  • Yeah that's the sort version, but if it's paying next month's payment (specially in the case of paying several month's payments worth extra) it directly functions against the interest. – coteyr May 29 '16 at 9:05
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    The bank assuming you are paying principal can also bite you. We sent in one of our mortgage payments early because we were going to be out of the country for a month. Even though we had included the correct coupon our bank just applied the payment to the principal and a extra payment for the previous month. Then dinged us for a late payment while we were out of the country. We could not convince them to apply the payment to the intended place and had to cough up an extra payment for the one we were "behind". That still rankles. – Ukko May 31 '16 at 14:54
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This only makes sense for extra payments, because for scheduled payments you've already agreed on how to split them between principal and interest. But extra payments can only be applied towards principal, right? Right, but the trick here is the "apply" word, not "principal"! Because if you just make an extra payment without saying what it is, the money won't be applied at all. Lender will assume they're for next next scheduled payment. Money will just sit there on 0 interest auxiliary account until the next scheduled payment will tick. This is why it's important.

Answer to your second question depends on type of the loan. Variable interest loans by definition need to be tracked separately, as nobody knows what the interest really will be for each interest adjustment period. For static interest loans (and even for interest-paid-upfront) it's sometimes better to track separately. A customer may decide to pay it off earlier and in some jurisdictions the lawmaker is very strict that "unused" period interest must be refunded in full.

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Some loans have a precomputed interest schedule. This means making early principal payments have no effect unless there is an way to recalculate the schedule --- which may not be possible or may require an explicit request.

1

There are two ways for "extra" payments to be accounted for:

  • they may be used to reduce the principal
  • they may be counted as pre-payments for future scheduled payments.

Let's consider the case of a loan where you are supposed to pay back $100 every month.

If on a given month, you pay $200, and ask for the extra $100 to be used to reduce the principal, then the principal will be reduced, and interest from that point on will reduce. You will pay less interest in total. Of course, your loan agreement needs to allow this (not all do, or there may be a penalty/fee for doing so, etc.).

One important point here is that in this case, the following month, you still need to make the regular $100 payment. If you don't, you'll be in default (late payment), as the extra $100 has been used to reduce the principal, and is not counted as the "next" $100 payment.


The alternative is that the extra payment be considered an advance for the next one. In this case, nothing will change in terms of principal, interest, etc. You're just really loaning money interest-free to the creditor.

This means that in this case, you don't need to make the "next" $100 payment, as you already have done it.

Note that likewise, this may not be possible for all types of loans. Some loans (most credit cards for instance) will automatically consider any extra funds (beyond the "minimum payment") to be applied to the principal, and you must thus ensure that you will make the minimum payment the following month.

1

So far, what most answers miss is, "It depends on the bank."

I just paid off a mortgage, on selling a rental property, and the entire time I made payments, it was all via my own bank's bill payer service. No check was cut, as I can tell when a payee gets a direct payment. Any time I made my next payment for more than the amount due, it automatically went to principal. The next statement received reflected that it was applied as I intended. To be clear, there was no payment ticket, as I never mailed them anything.

If this were exactly how every bank handled this, my answer would be, "Any funds you send in excess of the amount due will be applied to principal, no need to specify this. Just be sure you are sending a full payment, plus extra, don't try to make a partial payment mid-cycle."

It would take one such payment to verify this, and the occasional peek at your account to see that all is well. But, as others have answered, this is not true for every bank. If the payment does not contain specific instructions for the extra funds, they can be applied as you intended, or deposited to your escrow account, or set aside toward the next payment.

On a sidenote - that last comment, 'set aside for next payment' - Those who mistakenly think they can make bi-weekly payments and send in half every 2 weeks, actually want this to happen. Still, twice a year, when there are 3 half payments, their plan fails. The bank just keeps applying to the next month, and never properly applies the funds to principal only.

In the end, the TL:DR answer is "check with your bank." Since there's no universal way the all banks will handle this, and I assume you'll have at least a decade of this relationship, verify with your lender.

1

Paying your next payment early is different than paying down the principal.

Structured loans like Mortgages are designed so that the lending institution (or owner of the mortgage) receives a stream of relatively reliable cash. This cash flow (the interest/principal payments) both continue to demonstrate your credit-worthiness (that you can produce that cash), and are used by the institution to service their need for cash.

Imagine this is going on at a small scale. You are retired, and need a stream of cash. You have a pile of money, but only need some of it at any one time. So you go to someone and you help them buy a house.

They use your money and they guarantee you get the house if they default.

In exchange, they pay you X$ per month. This happens to be divided into principal and interest.

You live off that X$ per month. Maybe you are paying rent, or you buy food with it, or maybe you use it to pay for your travel habit.

If they go and give you another Y$ in addition to their X$ per month, you need to know if this money is an early payment of next months money, or intended to pay down the debt earlier (maybe reduce their future payments, or maybe reduce the term of the loan, depending on how the agreement is structured).

Depending on the terms of the loan, there may be difference between early payments and paying down principal. An early payment may go into a conventional bank account earning 0.25% annual interest; paying off the loan might reduce the principal, which is compounding at 3.5% annually. Or maybe early payments also get the 3.5%. It will depend on your agreement.

Paying down principal does not excuse you from paying monthly, while an early payment does excuse you from the next monthly payment.

Failing to make your monthly payments will annoy the person who is using your monthly payments to pay for food and/or airplane travel addictions. So knowing which the borrower is doing is important.

Financial institutions are this same thing, writ large. Here they have many mortgages out, and many income streams, and have plans for what to do with that income stream. Maybe they in turn sell annuities, acting as an intermediary.

In practice, many mortgages have limited bulk payment options, skip a payment options, and explicit rules about the difference between early payment and paying down principal.

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I think you are largely correct, so the only situation that this might matter is in the case of partial early payments in between regular payments. If you find extra cash under your sofa and decide to use that to pay a bit more of your mortgage than initially anticipated and just send the money to the lender, sometimes they will hold it in escrow until you can accumulate a full payment and then apply it to your loan. In this situation your interest is still accruing on the original balance, and you won't get any benefits at all unless you can save up a full payment, that extra cash will just be sitting in their account.

Some lenders however can apply it to your loan balance right away. Basically the impact will largely be driven by how good the lender's accounting systems are to be able to accommodate irregular payments.

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protected by Chris W. Rea Jul 9 '17 at 22:19

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