The fastest way to pay off any type of debt or loan is by paying off all of the principal as soon as possible. This makes principal-only payments an attractive option for those who have a lot of debt, especially high-interest debt from credit cards. While this type of monthly payment is not available from all lenders, a principal-only payment can save you big money on interest payments over time. Read more to learn more about principal-only payments and the pros and cons of making them.
The fastest way to pay off any type of debt or loan is by paying off all of the principal as soon as possible. This makes principal-only payments—which are often made as an extra payment—an attractive option for those who have a lot of debt, especially high-interest debt from credit cards.
While this type of monthly payment is not available from all lenders, a principal-only payment can save you big money on interest payments over time.
One example of a principal-only payment you may already be familiar with involves mortgage repayment. Many homeowners pay extra on their monthly mortgage payments and mark it “for principal only” to get their homes paid off sooner.
This article will explain what principal-only payments are and the pros and cons of making them.
What Is a Principal-Only Payment?
In most cases, when you make a regular loan payment, part goes to pay down the principal of the loan and part goes to the interest that is charged on the loan. For high-interest debt like credit cards, a large portion of your monthly payment goes to interest. This means that only a small amount of the principal is repaid each month.
When you make a principal-only payment, that entire amount goes toward paying off the principal on the loan instead of the interest. In most cases, principal-only payments are made in addition to your regular monthly payment. You can save a lot of money in the long run by making extra payments on the principal in addition to making your regular debt payments. This is especially true for debts with high interest rates. Making principal-only payments may also improve your credit score, in some cases.
This strategy is most effective when used with high-interest debt such as credit card debt. For example, if you have a credit card with a 27% APR, making extra payments to pay down the principal will ultimately decrease the amount of interest you’ll pay over time. That’s because interest is computed off of the principal. It can also work with lower-interest debts such as a car loan or student loan, but it will not make as much of a difference with them.
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Advantages and Disadvantages of Principal-Only Payments
In many cases, it makes sense for you as a borrower to make principal-only payments on your loans. Doing so shortens the life of the debt and saves you money in the long run. But in some cases, lenders charge a prepayment penalty, which could make paying off your debt sooner counterproductive.
To figure out if it’s worth making principal-only payments on a debt with a prepayment penalty, you’ll need to run the numbers. Determine which way will allow you to pay off your loan the fastest and with the least amount of money. In some instances, it may make sense to pay the prepayment penalty and be done with the debt sooner than scheduled. This may be the case when the interest rate is high. In other cases, a borrower will come out ahead by paying off the debt according to the schedule and avoiding prepayment penalties.
Lenders and Principal-Only Payments
Some lenders allow their borrowers to make principal-only payments to shorten the life of their loans. Many mortgage lenders do this as a courtesy to their customers who are on top of their payments and want to pay off their mortgages early.
But making extra principal payments when the lender has not specifically allowed for this opportunity can backfire on a borrower. As mentioned previously, if there are prepayment penalties, any extra money paid toward the debt may not all be allocated to the principal as the borrower intended. You should check with your lender before sending in a principal-only payment to see how this money will be applied to your debt. Lenders that do not allow this type of payment may instead direct the money toward both the interest and principal.
Know All the Details
As mentioned previously, some loan servicers will charge the borrower a fee if they pay off their loan before its term expires. Lenders may choose to do this to recoup the money that they lose when loans are paid off early. One example would be a homeowner who chooses to refinance their loan. You may see prepayment penalties on a mortgage loan, auto loan, and some student loans. But, most credit card companies do not charge this type of fee.
Prepayment penalties may be assessed when a loan is paid off before a certain time. For example, if a borrower takes out a 30-year mortgage and pays it off in 20 years, the lender may charge a substantial prepayment penalty to compensate for the loss of 10 years of interest payments. Many mortgages include a prepayment penalty clause so that borrowers don’t refinance right after they take out their initial purchase loan.
Borrowers who would like to make principal-only payments but are prohibited from doing so by their lenders can talk to their lenders to see what they can do. In some cases, a lender may be willing to waive this clause in the loan in order to keep a customer. If your lender won’t work with you on this, you can seek legal counsel to learn about what your state and municipal laws say about this.
Choosing an Optimal Strategy for Extra Payments
If your lender doesn’t charge a prepayment penalty or other fees for principal-only payments, you can get ahead by using your spare cash to pay off principal, one debt at a time. For example, you could start by directing all of your extra cash toward extra credit card payments. Then, when that loan is paid off, you can roll all of the money that previously went to that payment into the next debt payment and so on. This is called a debt snowball strategy.
There are many free online resources to help borrowers organize and track their debt payments. This way, you won’t get locked into making minimum payments on all of your debts for the rest of your life. You can start to feel like you’re finally getting ahead as you roll your extra cash into one loan at a time until all of your debt has been repaid.
In many cases, this is the most efficient way to pay down your debt, and it will look good on your credit history. Making principal-only payments in addition to your regular monthly payments can help you pay off your loans more quickly and achieve your financial goals that much sooner. And once all of your debt has been paid off, you can start allocating your money to funding other goals, such as retirement.
Making Principal-Only Payments
Different lenders have different rules about how to make principal-only payments. Some lenders will only accept a check that is specifically marked “for principal only.” Other lenders will allow borrowers to specify this designation online. Some lenders may only accept a principal-only payment by phone. Other lenders automatically apply any additional payments that are made to the principal. And, of course, some lenders don’t offer this option at all. Borrowers will need to consult with their lender to see what their policy is before making this type of payment.
When it comes to a mortgage loan, if you’re not sure whether you can make an extra payment each month, you can try to make bi-weekly payments instead. Many mortgage lenders offer home loans that amortize every two weeks instead of once a month for those who want to pay off their loans early. Under this schedule, you’ll pay half your mortgage payment every two weeks, but will end up making 13 full loan payments each year, instead of 12.
This can materially shorten the life of the loan in most cases because the loan balance will be repaid more quickly. Making a bi-weekly payment on your mortgage can help you pay off a 30-year loan in about 22 years, a 20-year loan in about 17 years, a 15-year loan in about 13 years, and a 10-year loan in about 9 years.
Making bi-weekly payments on other types of debt, such as car loans or personal loans, may also be possible, depending upon each lender’s policies and practices. Most lenders will not automatically allocate an extra payment that is made each year toward the principal of the loan. But they may do so if the borrower specifies this with their extra payment. bi-weekly payments are especially convenient for borrowers who get paid every two weeks.
Making principal-only payments can help borrowers to pay off their debts faster and save money on their loans over the long term. Some lenders do not permit this, while others charge a prepayment penalty of some kind to those who pay off their loans early. Borrowers should contact their lenders to see if they can get these penalties waived as a courtesy if their lender charges them.
Making bi-weekly payments is also a good idea, although your lender most likely won’t automatically credit an extra payment made each year solely to the principal. Mortgages are probably the most common type of loan that borrowers make bi-weekly payments on, but “extra” payments can also be made with other types of loans as well.