Some borrowers aren't concerned with paying down their loan principals early. Lenders allow a certain number of months or years to repay a debt, and borrowers need only submit their regular loan payments each month to meet their obligations. Making extra payments to pay it down the principal, however, has clear advantages, especially on a mortgage loan.
What is Principal?
Any loan taken out by a lender involves a principal balance and interest. Principal refers to the amount of debt, excluding the interest. Interest is an extra fee charged by lending institutions. This is the price borrowers pay for acquiring a mortgage loan, auto loan, student loan and other type of loan. The interest due to a lender each month equals a percentage of the principal balance.
Advantages of Paying Principal
Paying down the principal on a loan helps reduce how much you pay in interest over the life of the loan. The longer you have a loan, the more interest you pay. Paying down the principal reduces the amount of interest owed and can reduce the number of years you pay on the debt. For example, someone with a 30-year mortgage term making an extra principal payment each year can reduce the mortgage loan term by several years. This financial move helps free up money and can increase disposable income, allowing the property owner to increase personal savings.
Payment Options
Some options to pay down the principal on a loan are more advantageous than others. When applying for a new loan, you can arrange for a shorter loan term. For example, the average auto loan has a five-year term and the average mortgage has a 30-year term. To pay off the debt sooner, agree to a higher monthly principal payment and select a two or three-year term for an auto loan, or a 15-year term for a mortgage. For existing loans, consider making a full extra payment once a year, or add a little extra to each monthly payment to pay down the principal.
Warning
Before increasing your payments to pay down the principal, refer to your original loan documents to see if the loan includes a prepayment penalty. Some loans, including mortgages may have prepayment penalties. If your loan has a prepayment penalty, paying off the debt early can result in paying a fee to the lender (a percentage of the balance at the time of paying off the debt). Lenders include prepayment penalties to discourage borrowers from paying off loans or refinancing a loan, allowing lenders to recoup some of the financing costs. Prepayment penalties don't necessarily apply to the entire loan term; they typically expire, perhaps after three or five years.
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