3

Hopefully, my question doesn't sound dumb, because I'm not a finance guy.

Suppose I have a 100k loan, and the monthly payment is 1k.

My loan payment goes 600 to interest and 400 to pay down principal.

Next month, the total payment will still be 1k, but the distribution going to interest will be slightly lower.

Now, suppose I pay of most of it at once. Suppose I pay 90k this month, leaving me with a 10k left on the loan.

My monthly payment will still be 1k. But should most of that next payment go to principal and very little going to interest? Or is it still going to be roughly the same distribution as last month?

I'm asking, because people keep telling me that it's going to still be roughly 600 Interest and 400 principal. I'm trying to understand that. Wouldn't that mean I'm paying 600 interest/month when I only owe them 10k? Isn't that a huge interest rate? I've been told this twice, but it just doesn't make sense to me. Does that mean that paying off that 90k is harmful, because it'll mean I'll be paying a huge interest rate for what I still owe?

In my opinion, it would make sense that since I owe very little, most of my 1k monthly payment would go to principal, because I shouldn't have to pay that much interest?

7

The typical case would be - as you expected - that the interest goes down equally dramatically, and you would pay much less interest. Note that that does not remove your obligation to pay the full 1000 every month - even though you could argue that you are 90 months ahead in paying, you still need to deliver 1000 a month, until it is fully paid.

Some mortgages are made differently - they do not allow that. Basically, if you pay a large amount at once, it is considered a 'pre-payment' for the next x month. As a result, you are now x months ahead (and could stop paying for that much time), but your interest stays high.

The latter type 'protects' the bank against 'losing' the interest income they already planned for. As a balance, those type of mortgages are typically slightly cheaper (because the bank is in a better position).

You did not specify a country; in Germany, typically all mortgages are of the second type; but - you can get 1.35% mortgages... In the US, most are the first.

You need to check which type you have, best before you pay a large amount. In the latter case, it is better to invest that money and use it to pay off as soon as you reach the threshold; in the first case, any extra payoff is to your advantage.

  • Thanks for the explanation. I'm in the USA. So if I were to ask the question, how would I phrase it? What's the terminology for the two kinds you mentioned? – NL3294 Jul 7 '16 at 22:13
  • You speak to your lender and ask 2 questions. The first is: is there a prepayment penalty on this loan? (some loans have these to make up for lost interest) The second is: How would a 90k payment today impact the distribution of interest / principal on the remaining payments? – NotMe Jul 8 '16 at 0:34
2

It depends on the type of loan. Fully amortized loans have a schedule of payments don't recalculate as you pay. If you want to make an additional payment you need to contact the lender to apply your payment toward principle and reamortize the loan. Otherwise all your additional payment will do is change the amount due on your next payment, or push out your next payment due date.

Regarding interest calculation, you owe interest on the principle outstanding. Say you have a 10 year loan (120 Months), at 5% APR, and a $1,000 payment (this means you borrowed roughly $94,000)

 Month Principle    Interest     Payment 
 1     $94,281.35   $392.84      -$1,000
 2     $93,674.19   $390.31      -$1,000
 3     $93,064.50   $387.77      -$1,000
 4     $92,452.27   $385.22      -$1,000
 ~~~~
 80    $37,617.29   $156.74      -$1,000
 81    $36,744.03   $153.23      -$1,000
 ~~~~
 118    $2,975.17    $12.40      -$1,000
 119    $1,987.57     $8.28      -$1,000
 120      $995.85     $4.15      -$1,000

Each month the amount of interest owed reduces because there is less principle outstanding. The reason loans are amortized like this is so the borrower has a predictable, known, monthly amount due.

  • @NL3294 If you like graphs, I've found this answer to be very helpful in visualizing this sort of principal / interest breakdown over time. – user40002 Jul 8 '16 at 16:48
  • This answer clarifies things for me more than the accepted answer. +1 from me for a good explanation. – EJoshuaS - Reinstate Monica Nov 4 '18 at 16:15

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