How Making Extra Payments Affect Loan Amortization
19 Mar, 2016 / By Jennifer Hamilton
An amortized loan is a loan that you make scheduled periodic payments of both interest and principal. This is unlike those loans that you only make interest payments, balloon payments or negatively amortized payments for. Borrowers who decide to amortize loans are more likely to avoid payment shock than those who decide to take out a loan that isn’t fully amortized. Keep in mind that loans that are not amortized must become amortized at some point over the remaining length of the repayment term of the loan in order to repay the entire outstanding balance. If you have an amortized loan then you may be wondering what happens to it when you make an extra payment on top of the ones that are scheduled to occur each month.
Double the Principal
You may decide to make an extra payment by doubling the principal amount every month. This can reduce the length that you will be paying your amortized loan by almost 50%. It is typically much easier to find the extra amount early in the loan’s life, when a substantial percentage of the payments go directly towards paying off the interest and only a small portion goes to the actual principal. Even if you follow this schedule for the first couple of years, it can aid in shortening the numbers of years you have to pay down the loan, and drastically reduce the interest that you have to pay.
Making Annual Payments
If your salary includes an annual commission or bonus, or if you typically receive a hefty tax refund then even making just one extra payment every year can have an affect on how quickly you can pay down the amortized loan. For instance if you have a $200,000 loan over the next thirty years with a 6.5% interest rate then even making one payment every year of $1,000 will cut down the loan by almost five years, and lower the amount of interest that you must pay by nearly $47,000.
Making a One Time Payment
If you receive some amount of extra money then you may want to consider applying a portion of it to your amortized loan. Turning in a one time payment in order to pay down some of your loan’s principal will aid in paying off the loan early and save you on the loan’s interest. Keep in mind it is more beneficial to do this earlier on in the loan’s life. For instance, on a 30-year loan for $200,000 with a 6.5% interest rate, making a $10,000 one-time payment will result in a $35,000 saving in interest payments over the life of the loan if it is made after ten years. On the other hand, the same payment will only save you $15,000 if it’s applied to the loan at the end of fifteen years.
What to Keep in Mind Before Writing a Check
It is recommended that you look at your entire financial situation before you decide to make an additional loan payment. Make sure that your amortized loan is the best loan to make an extra payment on. If you have high-interest credit card debt for example, that may be more beneficial to pay down first. It is recommended that you talk with a financial advisor before making any additional mortgage payments if the mortgage has a pre-payment penalty clause in order to ensure you are making the best financial decision. Keep in mind that if your amortized loan has a low interest rate then it may be better to invest the money or pay off debts that are of higher interest rate first.