Does overpayment go to interest or principal?

That Extra Payment: Does it Tackle Interest or Principal First?

Many of us strive to pay off loans faster, whether it’s a mortgage, car loan, or student loan. A common question arises: when you make an extra payment, does that money go towards reducing the interest first, or the principal? The short answer is: it goes towards the principal.

This seemingly simple answer has significant implications for your overall loan repayment. Let’s break it down.

Your monthly loan payment is typically structured to cover two components: interest and principal. The interest portion is calculated based on your outstanding loan balance and the interest rate. This interest accrues daily, meaning it’s constantly growing on the remaining principal. The remaining portion of your payment goes towards reducing the principal – the original amount you borrowed.

When you make an extra payment, that additional money isn’t magically redirected to pay off accrued interest. Your lender doesn’t hold back a portion of your payment to cover interest first. Instead, the standard practice is to apply the entire extra payment directly to your principal balance.

This has a powerful effect. By reducing the principal balance, you immediately lower the amount upon which future interest is calculated. This, in turn, accelerates the repayment process. Each subsequent month, the interest portion of your payment will be smaller because the principal is smaller. This compounding effect saves you money over the life of the loan, ultimately resulting in lower total interest paid and a shorter loan term.

Let’s illustrate with an example:

Imagine you have a $10,000 loan with a 5% annual interest rate. Your scheduled payment might cover, say, $50 of interest and $100 of principal. If you make an additional $100 payment, that entire $100 is immediately applied to the principal, reducing your outstanding balance to $9,900. The next month, the interest calculated will be based on that lower $9,900 balance, and you’ll therefore pay less interest and more principal. This cycle continues, leading to significant savings over the long run.

The Benefits of Extra Payments:

• Reduced interest paid: The most significant benefit is saving money on interest.
• Shorter loan term: By reducing the principal faster, you pay off the loan sooner.
• Financial freedom: Paying off debt quicker frees up your finances for other goals.

While the method of applying extra payments is generally consistent, it’s always a good idea to confirm the exact procedure with your lender. They can provide a detailed breakdown of how your payments are applied and show you how much you’re saving by making extra contributions. By understanding how extra payments work, you can strategically accelerate your debt repayment and achieve your financial goals more efficiently.