Consumers borrow money in numerous ways. Young people often begin their use of credit with a student loan or by opening a credit card account. Car loans and home mortgages are other widely used forms of borrowing. All of these have a few things in common: You have to pay the money back, and lenders tack on finance charges. Only part of each loan payment you make is money toward the principal.
Anatomy of a Loan Payment
Consumers typically repay borrowed money with a series of monthly payments. U.S. News and World Report says that finance charges can represent much of that payment. Each loan payment is split up to cover several things:
- Lender's fees: Consumers can be charged fees in addition to interest on borrowed money. For example, a credit card issuer can add a variety of charges, including annual fees, cash advance fees, balance transfer fees and late fees.
- Interest charges: Interest is the price you pay for the use of a lender's money. The interest amount is a yearly percentage of the money owed.
- Money applied toward the principal or balance of the loan: The principal is the amount of the loan. The current principal, or outstanding balance, is the part of the principal that has not been repaid.
The Impact of Finance Charges
A credit card payment illustrates how finance charges cut down the amount of money that goes toward the principal. Suppose you have a credit card with a $720 outstanding balance, an interest rate of 18 percent and a minimum monthly payment of $20. If all of the payment went toward the principal, you would pay off the credit card in 36 months. However, 1/12 of 18 percent of $720, or $10.80, comes off the top for interest. Even if you don't charge anything and no other fees are assessed, just $9.20 goes toward the principal. At that rate it will take you more than six years to pay off this credit card.
If you add money to a monthly payment, the extra amount may go toward the principal, depending upon your loan type. This could shorten the time it takes to pay off a loan and save you money as well, because a lower balance means you owe less interest. Check with the lender before adding to your payment though -- some lenders only credit overpayment amounts against your next payment due unless you instruct them otherwise.
Some loans types feature interest-only payments. Examples include unsubsidized student loans and some mortgages. Suppose you take out an unsubsidized student loan to pay for college. You don't have to start repaying the loan until you stop going to school, but interest is added each month. You have the option of making an interest-only payment or letting the interest accrue, meaning it is added to the principal. When you make an interest-only payment, no money goes toward the principal, so you are no closer to paying off the debt.