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Understanding Principal-Only Payments
A principal payment is a loan payment that goes directly towards reducing the loan’s principal balance. The principal is the original amount borrowed, which accrues interest over time. In some cases, unpaid interest can be added to the principal balance, increasing the total amount owed.
For most installment loans, such as mortgages, a portion of each payment covers the interest and fees accrued since the last payment, while the remainder reduces the principal balance. Over time, as the principal decreases, less interest accrues, and a larger portion of each payment goes towards the principal.
What Is a Principal-Only Payment?
A principal-only payment is an additional payment made specifically to reduce the principal balance of a loan. This can help you pay off the loan faster and save money on interest. For example, if you have a $400,000 mortgage with a 6% interest rate and $2,398.20 monthly payments, making an extra $200 monthly principal-only payment can significantly reduce the interest paid over time.
Here’s a comparison of payments with and without extra principal-only payments:
| Payment | Principal | Interest |
|---|---|---|
| First Payment | $398 | $2,000 |
| 12th Payment | $421 | $1,978 |
| 24th Payment | $447 | $1,952 |
| 36th Payment | $474 | $1,924 |
| With Extra $200 Monthly Principal-Only Payments | $598 | $2,000 |
| 12th Payment | $632 | $1,967 |
| 24th Payment | $671 | $1,927 |
| 36th Payment | $712 | $1,886 |
Total interest savings over three years: $1,220. The difference in the remaining mortgage balance after three years: $10,820. Making extra payments and paying less interest can quickly add up.
Pros and Cons of Principal-Only Payments
Pros
- Pay less interest overall: Reducing the principal balance results in less interest accruing over the loan’s lifetime, saving you money.
- Pay off the loan sooner: Extra principal payments can help you pay off the loan early.
- Flexible payment amounts: You can make principal-only payments whenever you feel comfortable without committing to a fixed additional amount each month.
Cons
- Monthly payments remain the same: Your required monthly payment won’t change, even with large principal-only payments.
- Reduced available cash: Extra payments reduce the cash you have on hand for other expenses or opportunities.
- Potential lack of benefits: Some loans have precomputed interest or prepayment penalties, which may negate the benefits of extra principal payments.
Is It Better to Pay Principal or Interest?
Lenders typically apply standard payments to the interest and fees accrued since the last payment, with any remaining funds going towards the principal. While you often don’t have a choice, paying off the principal is the ultimate goal. If making extra payments, inform your lender that you want the funds applied to the principal balance.
If you’ve significantly reduced your loan balance, you might be able to recast your loan. Recasting adjusts your monthly payment based on the current balance while keeping the same repayment schedule and term. Although there may be a fee, recasting can lower your monthly payment without the need for a new loan application.
Contact O1ne Mortgage for Your Mortgage Needs
At O1ne Mortgage, we are dedicated to helping you manage your mortgage effectively. For any mortgage service needs, call us at 213-732-3074. Our team of experts is here to assist you in making the best financial decisions for your future.
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