Imagine being able to pay off a loan faster than the set term. It may seem like a dream, but it can be possible if you can make — and your lender accepts — principal-only payments.
Principal-only payments are a way to potentially shorten the length of a loan and save on interest. If your lender allows it, you can make additional payments directly toward the amount of money you borrowed — the principal — which can help you pay off your loan faster.
Let’s take a closer look at how you can make principal-only payments, the benefits of doing so and things to consider before you send extra payments to your lender.
- How a principal-only payment works
- How to make a principal-only payment
- Benefits of principal-only payments
- Considerations with principal-only payments
How a principal-only payment works
When you take out a loan, your monthly payment goes toward both the principal and the interest. The principal is the amount you borrowed. The interest is what you pay to borrow that money.
If you make an extra payment, it may go toward any fees and interest first. The rest of your payment will then go toward your principal. But if you designate an additional payment toward the loan as a principal-only payment, that money goes directly toward your principal — assuming the lender accepts principal-only payments.
Is an interest rate the same as an annual percentage rate (APR)?
An interest rate is the percentage of your principal that you pay to borrow money — but what is what is an APR? It’s your interest rate, plus any fees, expressed as a yearly rate.
How to make a principal-only payment
Making a principal-only payment may not be as easy as simply sending extra money to your lender.
Some lenders don’t offer the ability to make principal-only payments. To find out if you have this option, call your lender and ask if and how you can make a principal-only payment.
If the lender allows principal-only payments, make sure you understand the process and check that your payment is applied correctly. Some banks allow you to write a check and mark it “principal only.” Others might require you to go into a branch or — or more conveniently — allow you to make a principal-only payment online or by phone. Even better, some lenders may automatically apply any extra payment to your principal balance.
Benefits of principal-only payments
Making principal-only payments can benefit you in a couple ways.
Pay off the loan faster
By putting more money toward the principal, you can usually pay off the balance more quickly and reduce the overall length of the loan.
Pay less interest
Making principal-only payments can lower the total interest paid on the loan. When you pay down your loan balance, the interest that accrues on that balance typically also decreases.
Considerations with principal-only payments
Depending on your loan terms and your financial situation, making principal-only payments might not make sense for you. Here are a couple things to consider.
Prepayment penalties can defeat the purpose of making principal-only payments. If you pay back the loan early, some lenders may charge a prepayment penalty to recoup a portion of the interest they’d counted on collecting from you over the full term of the loan.
The amount of prepayment penalties and how they work can vary by lender. But typically, a prepayment penalty can kick in once you pay off the entire principal balance early, or when you pay a large portion of the loan at once. Making a principal-only payment here and there might not result in a prepayment penalty. Check with your lender to confirm whether your loan has a prepayment penalty and, if so, exactly how it works for your particular loan.
Other higher-interest debt
If you have other, higher-interest debt on credit cards, for example, it might make more sense to pay off that debt before making principal-only payments on a lower-interest personal loan or car loan. This could save you money in interest.
Using extra money to make principal-only payments can be a good move to reduce the total cost of your loan. The key is whether it makes sense for your financial situation — and you’ll need to review your loan paperwork or contact your lender first to confirm if and how they accept principal-only payments.
Finally, if you do go ahead with making principal-only payments, be sure to take a minute to review your loan statements and check that payments are applied correctly.