Term loan overpayment options: applied to principal, or...?

Question

Twice in my life now (as of yesterday) I've found myself in a very confusion situation after having made higher-than-scheduled payments on a term loan for an extended period of time.

The first time, years ago now, it was a commercial mortgage loan secured by a tract of undeveloped land. I decided I wanted to be paying a few hundred dollars more than the scheduled amount each month, so I set up an auto-payment through my online bill pay service; "set it and forget it." Many months later, it somehow came to my attention that an upcoming payment due amount was ridiculously low. I called the bank and asked them to explain, but I didn't fully understand. I think they were simply holding my overpayments in some sort of reserve area. In any case, they had not been applying the overpayments to the principal, and they said they needed me to tell them that that's what I wanted before they would do that.

Now yesterday my student loan servicer called me up to say my account was past due. They said I missed a payment recently, and that my change from online bill payment service to auto-debit (to get a 0.25% interest break!) took an extra billing cycle to go into affect. Anyways, when they told me the past due amount, it was significantly lower than my normal monthly payment. Upon investigation, we determined that my online bill payment service payments had been just a few dollars more than necessary, for many, many months. I would have thought that the overpayment would just be applied to my principal, but they said that was only partly the case. Despite their repeated attempts to explain, I just couldn't understand it.

People often tell me I'm smart, and I like to think they're right. And I like to think I've just about mastered the world of personal finance. But on both of the occasions described above I completely failed to get my head around the situation.

I used to think that it was standard practice to apply term loan overpayments toward the principal. I thought my first incident was just an anomaly, but after the second I'm dying to understand what's going on.

Is there a standard overpayment policy alternative to principal-application? Or are there multiple alternative policies? Is it normally safe to assume a principal-application policy? Or must we inquire about this policy for every single term loan?

Answer 1

It may have been the standard practice for a long time, and indeed it still is the common practice for my credit union to apply all excess payment directly to the principal.

At the risk of sounding a little cynical, I will suggest that there is a profit motive in the move to not applying excess payments to principal unless directly instructed to do so. Interest accrued isn't reduced until the principal is reduced, so it benefits the creditor to both have the money in advance and to not apply it to the principal.

You should probably move forward with the expectation that all of your creditors are adversarial even if only in a passive-aggressive manner.