Tori Dunlap Highlights the Sneaky Way Loan Companies Keep You in Debt

You don't always have to play by a lender's rules.

Tori Dunlap, an internationally-recognized money expert, has a bone to pick with lenders of all shapes and sizes. It involves how difficult lenders make it for borrowers to repay debt early. Fortunately, on her Financial Feminist podcast, Dunlap also offers advice for outsmarting sneaky lenders.

Understanding the basics

In writing her book Financial Feminist, Dunlap found that some women don't fully understand how a loan works. In fact, that was the number one reason women cited for going into debt or getting into more debt.

While Dunlap did not say it, it's safe to assume that many people -- regardless of gender -- aren't quite sure how loans work. We have a "rough idea" but don't always understand the details included in the loan contracts we sign.

The simple stuff

Most people understand that there are two parts to a loan: principal and interest. Let's say you take out a loan for $20,000 at 9% interest. Principal refers to the $20,000 that ends up in your bank account (or covering the cost of something you've purchased), and interest is the amount you have to pay the lender for borrowing the money. A large portion of each payment (especially in the early months or years of the loan) go toward paying interest, with little going toward whittling down the amount of principal you owe.

Where things get a little confusing

Most loans include compounding interest. Here's what that means: In addition to paying the 9% interest you agreed to pay when you borrowed the $20,000, you must pay interest on the 9% interest. That's right. Lenders charge interest on the interest you're already paying as though it's part of the principal.

Compound interest is a thing of beauty when you're earning on investments, but it's pretty stinky when you're trying to get out of debt.

You have to love Dunlap for quoting Albert Einstein here. Einstein is reported to have said, "Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn't…pays it."

How lenders can be downright sneaky

According to Dunlap (and everyone else in the free world), companies are out to make a profit. "So they're going to put everything in your way to help them make more money. This includes making it difficult or more difficult to pay off your loan sooner."

Let's say you have a personal loan or auto loan that you'd like to pay off early. You send an extra $100 each month, believing that the funds are paying down the principal. However, the company does not apply that money to the principal at all. Instead, they apply it toward the next month's payment or apply part to the principal and part to interest.

It may not seem like a big deal, but as Dunlap says, "Instead of just throwing extra money towards the loan generally, you want to contribute any extra money you have towards the principal of that loan." If you pay the principal down, you'll ultimately pay less interest.

The plan

Dunlop tells an interesting story of a time when she wanted to pay her car off early. Each month, she sent an extra $50 to Toyota. After realizing that the company was not applying the funds to the principal, she checked out the Toyota website. The car company did not want to make it easy, and its website gave no instructions for making principal-only payments.

When she called customer service, Dunlap said she spent 20 minutes on hold, only to be told that if she wanted to make contributions to the principal, she would have to send money to a random P.O. box in Iowa. She only knew because she called and asked.

Companies know that most people won't go through the trouble of calling and asking.

And that's where Dunlap's plan comes in. She says that if you have extra money to put toward paying off a loan earlier, call the lender. It doesn't matter whether it's a credit card company, mortgage lender, or another type of lender. Call before sending extra money. Make sure you know the lender's process for directly paying down the principal.

Dunlap's message is worth repeating: "Companies are not out to help you. They're out to keep you in debt because it makes them money."

Fortunately, once you figure out how to focus on paying the principal, it's within your power to chip away at it.