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If someone has an installment loan with equal, fully amortizing payments, and the borrower pays extra each month, how does the creditor decide whether to apply the extra as a prepayment to principal or as "paying ahead" to the next monthly payment due? For example, if the monthly payment is $100/m due on the 1st of each month, and the borrower makes this series of payments, how does the creditor decide how to apply the extra amount each month?

Pymt Date    |Pymt Amt
1/1/2000     |$110    |Does this reduce the balance by an extra $10?
2/1/2000     |$100    |Could the B. have paid $90 here because of the extra
                      |$10 paid the previous month?
2/15/2000    |$50     |The B. is current for Feb., so is this a prepayment 
                      |or does it go to the $100 due for March?
3/25/2000    |$200    |Is the B. paying March + extra? Or paying Mar + Apr.?
                      |Would the answer change if the B. owed a $5 late fee?
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    What do the loan terms spell out? – Chris W. Rea Jul 25 '16 at 20:56
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    See past answers, and the details of your own lian agreement. Some loans permit additional payments against principal, which does reduce the cost if the loan. Some will only accept the money as prepayment of future installments, which may help if you won't be available to make that payment but is otherwise not very useful. Some will accept either but you need to be explicit about what your intent is. – keshlam Jul 25 '16 at 21:07
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It is important to verify the terms of the loan, however, my experience has been that by default additional amounts paid will be applied to the principle balance of the loan. The full amount is still due on the next due date regardless of what I paid the previous month.

Some loans will give you the option to specify how you want additional funds applied. For a definitive answer on a specific loan I would suggest reading through any documentation that you got with the loan or contacting the lender.

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It depends.

Some loans do not allow prepayments/overpayments, and then it will be simply 'piled up' and considered 'paid on time' when it becomes due.

If prepayments are allowed, it depends on the willingness (customer-friendliness) of the loaning bank - some intentionally misunderstand it if you don't specify it, and some don't - so specify it.

Note that a prepayment (or overpayment), once understood as such, does not remove the need to pay the next payment on time.

Update: if you can afford it, and if it is allowed, it is a good idea - it is typically the best investment you could make with that extra money.

  • So, assuming the contract allows prepayment of the principal, and I send in some extra money each month without specifying what to do with it, it sounds like it's basically up to the servicer to decide what to do with the extra? Does that mean there is no "generally accepted accounting principal" or traditional practice? – WebUserLearner Jul 26 '16 at 4:09
  • @WebUserLearner YMMV depending on the country. I believe Aganju gave you the USA answer. In my country there is law enforcing loan companies and banks to accept prepayments, and any extra is considered a prepayment against the principal. – Mindwin Jul 26 '16 at 15:15
  • @WebUserLearner Loans can have a variety of conditions. Most loans that I have had apply payments over the amount due toward the principle balance. I have heard of loans applying the excess toward interest in such a way that there was no benefit to making excess payments. I would suggest avoiding such a loan as it benefits the lender far more than the borrower. There are a variety of loan features and conditions, it is important to know the details before signing the contract. – homer150mw Jul 28 '16 at 18:55
  • does not remove the need to pay the next payment on time. Sometimes it does. With my Chase auto loan, prepayments were applied to the principal, and pushed back the next due date. – RonJohn May 15 '17 at 14:21

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