The other day I was looking at the amortization for the loan I took out to buy our 2007 Honda Civic. The balance on the loan is now below $10,000 and I immediately thought about paying more on the loan just to get it paid off earlier.

But then I noticed something that I never really noticed before (I noticed it before but never really thought about it): My extra payments wouldn’t save me that much in interest. Why? Well, it has to do with the way loans are structured. When you take out a loan, the payment is calculated based on the length of the loan, the interest rate on the loan, and the amount of the loan.

For example:

I’ll use our Honda loan as an example. Here’s the necessary information:

**Interest Rate: **7.3645%

**Period Rate: **0.6137%

**Loan Term (Years): **3

**Payments per Year: **12

**Total Number of Payments: **36

**Amount Financed: **$15,019

**Payment Amount: **$466.26

Here’s what the amortization for this loan looks like (you can click on it to see a larger version):

Take a look at the first payment:

The beginning balance is $15,019. The interest portion of the $466.26 payment is $92.18 which is calculated by multiplying the beginning balance ($15,019) by the periodic rate (0.6137%). The remainder of the payment is applied to the principle, which becomes the beginning balance of the following month.

Each month the balance on the loan decreases, which makes the periodic interest payment smaller. This leads us to the point of this post:

In order get the most benefit from making extra payments on a loan, you need to make them at the beginning of the loan. How much difference does it make? Let’s see.

I ran two scenarios. The first one assumed an extra $50 each month for the final 18 payments and the second scenario the extra $50 was applied to the first 18 payments. Here’s what the two amortizations look like:

Under the normal amortization for this loan, the total interest charges for this loan would be $1,766. By making extra payments at the end of the loan, you would pay $1,720 in interest, giving you savings of about $46. By making extra payments at the beginning of the loan you save $155 in interest. No, it’s not a lot of money, but this is a short-term loan. Imagine how much the saving would be if this were applied to a mortgage.

Of course there are other things to consider when doing this math. For instance, you have to look at the opportunity cost of the $50 you are putting towards paying off the loan early. Could you put that money to better use elsewhere? That’s something you have to ask yourself.

Anyway, the next time you are tempted to accelerate the payments on a loan, ask yourself how much you are actually going to save by paying it off quickly. You might be surprised to find out it’s not as much as you thought.

This seems obvious to mean. Its the same with saving. You will earn more interest putting in a 100 dollars today than if you put it in 5 years from now. You aren’t really earning or saving anything more. Because all your calculations of what you can do with your money otherwise are in the short term.

Don’t disregard the emotional & psychological boost from paying off a loan early. If you’re in debt up to your armpits, seeing some headway is quite a boost. I’ve got a couple that are coming close, and I’m licking my chops!

Speaking of mortgages, it seems that the conventional wisdom is/was that a person should refinance a mortgage once the going interest rate drops by a certain amount (2%, IIRC) below that of the original loan. But this doesn’t take into account how long this person has held the original mortgage — there WILL come a point where the additional interest paid by extending the loan another 30 years will end up costing more than the savings from the lower rate.

What I hate about my car loan is that I see the interest go up and down depending on when they receive my payment. One month my interest could be $50 and the next could be $55. It is unlike my mortgage and HELOC where the interest payment always goes down. It must be because my car is a retail loan that the interest. Seeing this interest go up after I paid money towards the loan makes me hate the bank and just want to pay it off even sooner. The loan started off on the wrong foot when they were sneaking in monthly charges for “insurance” or something similar. At least I have a decent rate of 5.35%

I suppose I’m being picky, JLP, but as a matter of principle, someone in the financial services business should know the difference between the words “principle” and “principal.”

Yep, this is something I thought about recently too. I’m only a few years into my mortgage, but I’m not in any position to pay extra yet as I still have credit cards and some student loan debt to eliminate. By the time those are done, I’ll have missed a lot of the great money saving opportunities on early mortgage payments.

This happens with a mortgage also. If you have a 15 year mortgage, you home is paid for after 15 years, but if you take out a 30 year mortgage after 15 years you will still owe about 66% of the original mortgage. In other words you have only paid off 1/3 of the principal.

Dave,

You got me. I know that and yet I still messed it up. I’ll fix.

as long as the interest you get on a savings account is only 3-3.3% at best and your car loan and mortgage are at interests above 5.75% it makes sense to pay these loans sooner if you have the extra cash and have enough in savings to get you over a rough financial patch ( your financial cushion).

we have always payed our high interest car loans 1-2 years earlier because of lower return we get from our savings account. I kept up to the term only a 3 year 1.9%APR loan we got 5 years ago on a VW car as the interest of our savings account was then above 5%.

if you invest in stock it may be better or it may be worse, you never know for sure. and I tend to invest in equities only for long term ( IRA and the such) as these are money I will not be spending ( bar a dire emergency) for another 25-30 years.

congratulations! you just learned the lesson of compound interest! You are earning (or in this case paying) the same rate on your money regardless of when you pay the amount – your loan interest rate is 7.4%. You pay this on the outstanding balance every month. The lower the balance, the lower the interest payment. But your return is always the same – 7.4%. If you can earn more on your investments than 7.4% (pretty hard to do right now) than don’t pay it off early. If not, than pay extra and get the loan off your back and earn 7.4%. Irreregardless (Dave – don’t sic the grammer police on me), the interest rate is the determining factor.

@Kevin,

Car loans are typically daily interest loans, whereas mortgages are fully amortized interest loans. When you pay extra on a mortgage payment, it doesn’t change the amount of interest owed because the interest is pre-calculated on a fully amortized schedule. Car loans accrue interest daily, so the date that you pay the loan resets the interest owed to zero on that day. This is why I pay my car loan in two payments; the full payment on my first check, and an additional payment on my second check. By doing this, you are lowering the interest owed by resetting the interest to zero with each check, rather than applying the whole payment to the principal.

Home equity loans and HELOCs are done the same way. Do a google search on the difference between a fully amortized loan and a daily interest loan.

I thought you understood the concept of time-value-money.

lex said:

“I thought you understood the concept of time-value-money.”I understand it, but I thought AFM readers would enjoy the illustration.

I appreciate your very thoughtful comment, though.