If you’re about to take out a loan or already have one, check the loan terms to see if you can make early payments so that you can clear the debt off your credit report faster and lower the total cost of the loan. This applies to consumer loans like home mortgages and small business loans. By making payments above what you owe on the payment cycle, you can likely lower the amount of interest, thus saving you money over the life of the loan.
Early payments are common and can be made in:
- Bimonthly payments
- Curtailments
- Balloon payments
- Lump sums, if you’re going to recast the loan
Ready to learn how this strategy saves you money and to see if it is applicable to your loan? The guide below walks you through how early payments or multiple monthly payments can save you money, and where to look in your loan agreement to see if you are able to use these strategies.
How Early or Multiple Payments Help You Save Money on Loans
Suppose you have a loan for $100,000 (the principal) with a fixed interest rate of 3% and a monthly payment of $1,000.
In this case, interest for the first month is $100,000 x .03 / 12, which is $250. You subtract this from the total loan payment of $1,000, which means $750 goes towards the principal and $250 goes to the lender. The new principal is now $99,250. The next month, you’ll pay 3% in interest on the $99,250, using the same formula, and the remainder of the $1,000 will go toward the principal.
The second month, interest amounts to $248.13, with $751.87 going toward the principal. If you had an extra $250 and your loan terms allow for additional payments, you could lower the principal amount further, reducing the total amount of interest you’re paying and helping you save money.
If during your first month, you make an additional principal payment of $250, your next interest payment becomes $247.50 instead of $248.13. By applying this method, you can get your loan paid off faster and reduce how much you spend in interest. This may not seem like a lot of money, but when the amount of the loan is large or interest rates are high–and you multiply them across how many payments you are required to make–the dollar amount adds up.
By following this approach, you are paying the lender less money for their financing, as their profit comes from the interest you pay. That’s why some lenders will not allow additional payments or early payments, and if they do, there may be a prepayment penalty or fee depending on the amount you pay toward the principal early.
Another loan term to look out for is whether the interest rate is fixed or variable. If you have a fixed rate, your payments will use the formula above. An adjustable/variable rate means you’ll have to check if your lender increases or decreases the interest rates based on the market, which will require you to modify the formula with the new numbers.
What to Look for in Your Loan Terms
There are a few terms to look for in your loan agreement to determine what your repayment schedule looks like and if you can make early payments, multiple payments, prepayments, and/or curtailments.
One important note to keep in mind is that the time frame to repay the loan is referred to as the “loan’s term.” This is the length of time during which you’ll be paying the loan back, not to be confused with the “terms of the loan,” which are the conditions you and the lender agree to. You’re looking for the latter in this case, as the terms of the loan may be negotiable.
They include:
- Promissory notes which are in the body of the document and outline the payment terms.
- The repayment schedule to know your timeline for making payments.
- Interest rates, which show you the percentage you owe on the principal and if you have an adjustable or fixed rate.
- Prepayment penalties, which are when a lender can charge a fee if you’d like to do multiple payments or pay the loan off early, which would result in them collecting less interest. These stipulations vary based on loan type. Some examples include: hard, soft, step-down, defeasance, flat fees, and special conditions–like where you’re exempt from penalties if you pay under a specific amount/percentage of the remaining balance.
When Making Prepayments and Multiple Payments Make Sense
When you plan on taking out another loan for financing equipment or expanding your business, or you have excess cash flow, it may make sense to make extra payments.
The amount of debt you owe is on your personal and business credit scores, and by reducing the loan amount, you may be able to decrease your risk level as a borrower. This is important if you’re applying for more business financing or personal loans, as lower-risk applicants have a higher chance of getting approved.
Investors like to start making their money back and collecting their net gains as quickly as possible. By owing less money to third parties, you may show that your business is financially sound, or that you can begin paying them back on their investments more easily. If you have heavy debt, it could be seen as a risk to some investors but not all. If the investor has experience in turning similar businesses around, they could see it as an opportunity.
If you have a windfall (an unexpected spike in earnings or profits), it may make sense to make early payments on your loan so that you can save more money over the long run and not have to reduce your cash flow since there is excess. This is especially true if there is no need to hire new team members, salaries are competitive, and you don’t need to replace equipment.
For seasonal businesses, reducing your business loans with bimonthly and early payments during peak seasons can make managing the loan more bearable during slow seasons, as you’ll be seeing the principal and owed amount drop. Even if you still have to make the same monthly payment amount, the peace of mind of the lower principal could be worthwhile for some business owners.
In the case of real estate investing and businesses that take loans regularly, making a lump sum payment to recast the loan (a type of loan re-amortization) lowers the amount of debt on the public record. Thus, these businesses appear to be lower-risk as they apply for more loans for their next projects or business ventures. These can include acquiring businesses and rapidly expanding franchises. The downside here is that lump sums decrease your cash flow, so make sure you have enough to cover the project and make the down payment on the new loan.
Making early payments and bimonthly payments can be smart ways to save money over the life of a loan. If you have the money to do it and your lender allows you to, give it a try. You’ll have more cash flow in the long run and may be able to pay off your loan faster.
