KANSAS CITY, Mo. -- You probably have some kind of monthly loan payment. If you don’t understand how that loan gets paid off, you may mishandle your payments and risk hurting your credit rating. It is important to understand how loans work. Kathy Stepp with Stepp and Rothwell shares how loan payments actually work.
- ‘Regular’ loan payments are amortized. This means that the payment is calculated so that the entire loan (interest and principal) is paid in even monthly installments over a stated period of time.
- Home mortgages and car loans are common examples of amortized loans. Each payment consists of interest and principal. The interest is calculated first, based upon the outstanding balance from the previous month. The rest of the payment reduces the outstanding balance (principal). Therefore, any amount paid more than the required amount will reduce principal.
- If an extra principal payment is made, the result is that the interest charged on the next monthly payment will be less than planned, because the outstanding balance (principal) is less than planned. Therefore, more of the next planned payment reduces principal. The result is that the loan is paid off sooner. However, it is important to note that making extra principal payments does not change your future monthly payment amount obligations! Again, your loan will just be paid off sooner.