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Choosing to make extra payments on a loan has two big benefits. First, the additional payments reduce the term of your loan. Second, because you'll be repaying the principal early, you'll save money on interest. You may be surprised at the difference a small extra payment makes, and an amortization calculator can show your potential savings.
How loan amortization works
When you obtain a loan, such as a mortgage, auto loan, or personal loan with a fixed term, your payment amount will be the same over the life of the loan. However, the composition of those payments will change over time. Specifically, your earlier payments will mostly go toward interest, while your later loan payments will pay down more of your principal.
As an example, if you obtain a $25,000 car loan at 5% with a 60-month term, you'll pay $472 per month. Here's how this will be distributed for your first three loan payments and your final three payments:
|
Payment Number |
Interest |
Principal |
|---|---|---|
|
1 |
$104 |
$368 |
|
2 |
$103 |
$369 |
|
3 |
$101 |
$371 |
|
58 |
$6 |
$466 |
|
59 |
$4 |
$468 |
|
60 |
$2 |
$470 |
Data source: Loan amortization calculator.
As you pay some of the principal down, you'll be paying interest on a lower outstanding balance and will therefore pay less and less interest as time goes on. The mathematics of loan amortization are beyond the scope of this article, but the general idea is that the more of the principle you pay off, the less interest you'll pay per month, and as a result, you'll end up paying the principle down faster and faster.
The benefits of paying extra
I mentioned in the introduction that there are two big benefits to paying extra on a loan, and they both have to do with the amortization concept I just discussed.
By paying more than you have to on a loan, you reduce the remaining principle on which interest is applied. Therefore your next payment will have a smaller interest charge than it otherwise would, and more of your payment will be applied to the principle. If you continue to make additional payments, the cycle repeats itself.
The net effect of this is that you'll end up paying off the loan faster, and you'll also save yourself money in interest. On a large loan with a long repayment term (like a mortgage), you may be surprised at how much you could save.
Take this mortgage example
Let's say I just obtained a $250,000 30-year mortgage at an interest rate of 4%. This translates to a monthly payment of $1,194, and I'll end up paying a total of $179,674 in interest over the life of the loan.
After looking at my finances, I determine that I can comfortably add $300 per month to the payments. Per the amortization calculator, this would allow me to pay off the loan and own my home free and clear 9.5 years earlier than if I simply made the scheduled payment amounts. Perhaps even more significant, adding $300 to my monthly payments would save me a staggering $62,910 in interest over the life of the loan.
To recap, by increasing my monthly payments by roughly 25%, I would pay off the loan 32% faster and save 35% on my interest expense. Imagine if I had increased the payment by $400 or $500 instead.
How much could you save? Here's an amortization calculator that is specifically designed to determine the effects of paying extra on your existing loans:
* Calculator is for estimation purposes only, and is not financial planning or advice. As with any tool, it is only as accurate as the assumptions it makes and the data it has, and should not be relied on as a substitute for a financial advisor or a tax professional.
As you can see, the savings can be significant in terms of both time and money. It's generally best to pay off your high-interest debts, such as credit cards, before paying extra on your mortgage. But if you're in the financial position to add a little bit to your monthly payments, then it could save you thousands -- or even tens of thousands -- in unnecessary interest payments.
