The amount of money you have left on your loan is called the principal. Making a "principal payment" involves making payments on top of, or in addition to, your monthly dues. So if you paid $200 as a part of your regular payment schedule and $100 on top, the $100 payment would be the principal payment.
Why bother making principal payments? First, it can save you dough. Second, it may boost your chances of getting another loan down the line. As part of our money management series, we'll discuss each of these benefits in detail.
How making principal payments saves you money
Your loan's amortization schedule, which is really just a fancy way of saying "your loan payment schedule," details how much money you'll have to pay the lender each month. A portion of this payment will go toward the interest on the loan.
Suppose you took out a five-year, $14,000 auto loan at an interest rate of 4 percent. According to your monthly amortization schedule, you'll have to pay the lender $257.83 a month. Over the life of the loan, about 10 percent of those payments (i.e. the loan's interest) will go to the lender.
What this means is you'll actually end up paying the bank $15,469 in the long run – or $1,469 in interest. Making principal payments, however, will reduce this figure.
Think of it this way. If you make additional payments of $100 on the principal every month, you'll pay off the loan in about three and a half years instead of five. At the end of the day, you'll pay about $430 less in interest because you've proactively reduced the loan term.
Making principal payments could help you get a mortgage
One of these days, you're going to want to buy a house. Depending on your credit report, which details your loan payment history, your mortgage interest may be high, low or average. It turns out that making principal payments could not only improve your chances of getting approved for a home loan but also likely reduce the interest you'll have to pay.
Why? You've probably heard of Fannie Mae – the government-sponsored enterprise that creates mortgage-backed securities (but that's for another article). It turns out that Fannie Mae produces a piece of software called Desktop Underwriter (DU), which allows lenders to underwrite loans.
Underwriting is the process of calculating the risk associated with lending money to someone. According to Fannie Mae, the latest version of DU will allow underwriters to see whether you make loan payments on time and in full. By making principal payments, a loan officer will see that you proactively pay off debt, and are therefore a lower risk to the business.
Granted, you may not have the extra cash needed to make principal payments every month. However, if you do happen to have some extra dough, seriously consider putting it toward the principal. If you can afford to do so, use a portion of your tax returns to make a principal payment.