What Is a Principal-Only Payment?
Loans can get expensive, and over time, interest compounds, forcing you to pay higher fees to service your debts.
Principal-only payments are a great way to reduce your total fees. By paying off the principal – the sum of money originally borrowed – these payments allow you to shorten the period of your loan and save on interest.
In this post, we’ll take a closer look at what a principal-only payment is and how you can use it to your advantage.
How a Principal-Only Payment Works
On most conventional loans, repayments cover both the principal and the interest.
Suppose, for instance, you took out a personal loan of $100 – the principal – with a monthly interest rate of 5%. At the end of the first month, you would owe $105 since 5% of $100 is $5 of interest.
If you made a repayment of $10, it would reduce the total amount that you owe to $95. The first $5 of the repayment would go towards interest charges and the second $5 towards paying down the principal.
When you make a principal-only payment, you are essentially making an extra payment that reduces the principal beyond any interest that you have to pay.
For instance, let’s say that you paid back $15 in the first month. The additional $5 on top of the original $10 would be a principal-only payment since it reduces the principal, not the interest.
Not all lenders accept principal-only payments. If they do, they might charge extra fees to compensate them for the interest payments that they would have received otherwise.
Making a Principal-Only Payment
Begin by checking whether your lender accepts principal-only payments. Some will, but others won’t let you deviate from the repayments agreed in your contract.
Bear in mind that lenders can make mistakes. So, if the lender allows principal-only payments, you’ll need to make sure they apply your extra payment correctly. You’ll also want to ask them about any extra fees that you may incur.
Lenders may also specify how you can make a principal-only payment. While most will let you make a principal-only payment online, some may require you to do so in person or send physical checks in the post. If you send checks, banks may allow you to mark the extra payment as “principal-only.”
The most accommodating lenders offer automatic processing. You can apply extra repayments directly without having to jump through any hoops like paying fees or calling customer service representatives.
Benefits of Principal-Only Payments
There are two major reasons why people make principal-only payments.
Reduce Interest Payments
Firstly, when you pay down the principal on your loan faster, you reduce the total amount of interest the lender can charge at the quoted rate.
Going back to our example, suppose you paid back $10 after the first month on the $100 loan accruing interest at 5%.
The next month, the principal would be $95 and the interest payment would be $4.75. However, if you paid back $15, the interest payment would be $4.50.
What's more, this simple example understates the dynamic effects of paying off more of the loan at the beginning. Over the course of all payments, the total amount of interest paid is significantly less because less interest is being charged with each successive payment.
Pay Back the Loan Faster
Secondly, when you put more money towards the principal, you also pay back the loan faster. Interest has less time to accrue, accelerating your ability to repay the loan.
Should You Opt for Principal-Only Payments?
Whether you opt for principal-only payments depends on your financial position and the opportunity cost of capital. In some situations, extra payments may make sense for you, but not always.
Yes, if your debt interest is high
If the debt interest on the loan is high, then the opportunity cost of allocating capital to pay it off is low. That’s because it’s unlikely that you’re going to be able to generate higher returns elsewhere, so it makes sense to eliminate the liability first.
No, if you have other high-interest loans
Opting for principal-only payments on a low-interest loan isn’t advisable if you already have an outstanding high-interest loan. Any additional money should go towards settling the more expensive loan first.
Yes, if you can avoid prepayment penalties
Lenders want to make as much money as possible, so when you commit to paying back loans early, they don’t like it. It denies them interest payments in the future.
Some lenders charge prepayment penalties – extra fees for paying back loans early. However, these vary considerably by lender and loan type. You’ll want to check what the terms are first before making any additional payments.
No, if it means going hungry
If making additional loan payments results in lacking life’s necessities or failing to pay your bills, then skip it.
If you have a bit of extra money laying around, then it often makes sense to contact your lender and ask them if you can make a principal-only payment. These let you reduce the cost of borrowing over time and shorten the repayment horizon. The greater the payments you can make early in the life of the loan, the bigger the savings will be overall. Just keep an eye out for prepayment fees, as these can sometimes be more expensive than simply paying the interest.
Is it better to pay the principal or interest?
It depends on your objectives. If you have a high-interest loan and the opportunity cost of capital is low, then it makes sense to pay off the principal. However, if the interest rate on the loan is low and the opportunity cost of capital is high, then it makes sense to just pay off the interest.
Do principal-only payments lower monthly payments?
Principal-only payments increase payments in the short term but lower them in the long term. When you pay back a larger percentage of your principle, you reduce the amount of interest that you owe on future installments (even if you revert back to your original payment plan).
Can you pay off just principal before interest?
In every accounting period, your lender will charge you interest. The interest is treated as part of the principal for the next accounting period. For this reason, you always need to pay off the interest first in any accounting period before you pay off the principal. Once you pay the interest, any additional payments you make within the accounting period apply to the principal balance.
I have always thought of myself as a writer, but I began my career as a data operator with a large fintech firm. This position proved invaluable for learning how banks and other financial institutions operate. Daily correspondence with banking experts gave me insight into the systems and policies that power the economy. When I got the chance to translate my experience into words, I gladly joined the smart, enthusiastic Fortunly team.
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