What Happens When you Make an Extra Payment on a Loan?

What Happens When you Make an Extra Payment on a Loan?

It is really interesting to see the results of making an extra payment to a mortgage, auto loan or any other amortized loan.  I think there is some confusion as to  what exactly happens, mathematically, when you make the extra payment.  To understand what happens when you make an extra payment you first have to know if you have an amortized loan.  The definition of an amortized loan is “a loan with scheduled periodic payments of both principal and interest. This is opposed to loans with interest-only payment features, balloon payment features and even negatively amortizing payment features.”

An Example Amortization Table

For our example I am going to use a very common auto loan:

  • $20,000 Car Purchase
  • 60 Month Pay off
  • 5% Interest Rate

This gives us a payment of $377.42/month, however, each payment will be made up of differing principal and interest amounts.

First Half of Amortizing Auto Loan

Second Half of Amortizing Auto Loan

Your payment doesn’t change but the interest per month goes from $83 in the first month to $1.57 and the principal payments go from $294 to $376 (you may have to click the pictures to zoom in).

Adding an Extra Payment to an Amortized Loan

Now lets add an extra $50/month to our payments.  As I learned the hard way you may have to tell your auto financing or mortgage company that you wanted any extra payments added to the principal (a long time ago I had a problem with my extra auto loan payments going to future payment rather than going to principal).

First Half of Amortizing Auto Loan with extra payment

Second Half of Amortizing Auto Loan with Extra Payment

You may have to zoom in to see the numbers clearly, but what is happening is that all those extra payments are going to the later payments effectively erasing those later interest payments.  That is the reason why bloggers and pundits say prepaying debt is like getting a guaranteed return.

In the above example paying an extra $50 saves 7 months of payments and $352 in interest payments.

Do you Prepay your loans? What system are you using? Rounding up, specific amounts?

24 Responses to What Happens When you Make an Extra Payment on a Loan?

  1. We are currently adding extra to our house payments. At first, we rounded up to the next hundred. For example, our payment was 670.00 dollars. We paid 700.00 dollars. As of late, we are now paying 750.00 dollars… and we hope to increase that amount over time.

  2. I know that paying extra on loans will save you money but it’s not worth the hassle for me. I set a budgeted amount to pay per month and just pay that amount. If I somehow come upon a windfall and am able to pay it all back though, I will.

  3. When I saw the title of your post, I was about to say ‘be careful, shady companies apply the extra payment towards future interest rather than the principal’… but I see you are aware of that! :)

    Seriously, I hate it when banks pull this kind of crap. Why would anyone prepay interest?

    Also, some lenders have a pre-pay penalty, be wary of those as well.

    Thanks for putting together the table – that is a lot of savings!

      • My auto loan company is doing this to own increase payment. They are using the extra money toward interest. How do I get them to apply it toward principal?I pay through ebanking. I took a look on their payment website and didn’t notice a box for me to check to apply any extra monies toward principal.
        So why doesn’t it help me to have them apply the extra monies to interest?

  4. Yep, the earlier you pay down, the more interest you save from that single payment. That works the other way as well: The earlier you invest, the more you’ll gain in compound growth. Whether you pay down debt or invest depends on your own risk assessment, goals, and the risk-adjusted rates of return on both. I think there’s a place for doing both, since it doesn’t have to be all-one or the other.

  5. I pay extra on my mortgage every month,which works out to about adding 2 extra payments a year. I just hate debt, which is why I do it. That is about the amount I can afford while maintaining my savings goals.

  6. It’s all about the present value of money and future value of money. Especially with 30 year mortgages, those “systems” (which are total BS) like to highlight all the interest you’re saving but it’s basically just inflated future dollars. Had the same payments been invested in equities or basically anything returning about 4% or more, you’d be better off. With the mortgage interest deduction and rates in the low 4s, effective mortgage rates are below 4% for anyone w good credit these days.

    The only benefit I’d see (which I am considering) is to time the end of a loan to correspond with some particular transition – like when my kids hit college – so I can shift from paying a mortgage to paying for college (when does it end?).

    • It never ends!

      No system was being used here, just a simple amortization table. You could 100% invest what you would put towards it, but how many people follow through?

      I like InvestItWisley’s idea of doing both.

  7. I used to pay the regular amount monthly on my car loan and then when I had a windfall I would pay that extra and ask them to apply it to the principal. Depending on the representative I would get it applied to principal but some of them did the ‘future payment’ thing which was really annoying and the supervisor would not override it. It really helps when you can make an extra payment.

  8. I do prepay my loans, and I do them 1 at a time using the debt snowball method. Currently, I’m working on prepaying my student loans, and then I’m not sure which debt that I will move on to.

  9. I pay extra each month on our auto loan and the payment amount keeps getting lower. I still pay the same amount each month ($400) as that is what we have in our budget. Do I contact Chase and ask them to recalculate our loan with the extra payment to principal (which I ask them to do with each payment made). If they won’t do that what else can I do to get our loan paid off earlier?

    • Auto loans aren’t amortized like residential mortgages. You pay the same principal and interest on an auto loan so you don’t get the benefit of paying early (other than getting rid of the debt). If you have a low rate like 0.9%, it’s probably not worth pre-paying. You can make more elsewhere. If high interest, by all means, pay it.

      • The interest rate is 8.49% so I’ll keep paying the higher payment and pay this thing off early. I did notice that a couple of months ago Chase added an option “additional principal payment reduction” option when paying online (which I have done from day one and pay all my bills online). I have started paying the minimum payment and the extra payment in the principal reduction option which will help lower the principal balance.

  10. Ah, neat stuff. I had a decent understanding of this already (read as much about personal finance as I have, and how can you not?) but never bothered to come up with an amortization to prove it. Good stuff though; it’s amazing how much a few extra bucks each month can end up saving you.

  11. Thanks for this post and the link to your extra loan payments post! My income has recently increased and I’ve been getting some unexpected bonuses.

    I thought I did great by creating a short term emergency fund, and now throwing all of my extra money into paying off my car.

    I just realized this month that my next due date is not until April 2012… My extra payment is not going toward my principal! I looked at my loan account online and saw that if I pay directly from the loan holders website (rather than from my online banking account), there is a an option to pay directly towards the principal. Looks like all my payments will go toward principal exclusively, from now through April, after which time I will divide it accordingly.

    All of this is new for me, so I’m really excited to figure this out now. Thanks again!

    • Jentree,

      I am so happy this helped you out! That is literally the exact same thing that happened to me. As soon as I realized it I destroyed the auto loan. I hope you check out my other posts.

Leave a reply


− 1 = 2