Michael on March 21st, 2008
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Based on the strong response, there’s definite interest in adding a Q & A element to this blog. Read more about the new Q & A feature, but the short answer is to email your questions and I’ll answer some of those based on originality, usefulness to other blog readers, and my general mood at the time.

Here we go:

I have student loans. I want them to go away. I have been paying a wee bit more per month than they require: they want $117, I send $125 (for no specific reason). They are never ever ever going to go away at that rate!

My current plan is to save cash in a savings account, then periodically throw a chunk of change at the loan balance.

My question: do I need to declare that the overage be applied to the principal? I have heard that advice before, but to my mind it doesn’t make sense. I don’t trust the companies and am sure they’ll look after their own interests before they consider mine, but if interest is charged monthly, how could extra money be put toward future interest? Is this a fine print thing, or is it an urban myth that we have to tell them how to apply extra funds?

I look forward to the answer!

Beth

STRAIGHTFORWARD ANSWER: Yes, it does matter. Write “apply to principal” on your checks.

More detailed explanation:

Part of every payment you make on any loan goes to interest and the rest to principal. Since the interest charged is the intererst rate multiplied by the principal owed, reducing your principal today reduces the interest you’ll pay tomorrow.

When you pay the minimum, or exactly what is owed based on the payment schedule, everything is remarkably simple. But if you pay $125 when only $117 is due, where does the lender apply the extra eight bucks? To principal? To interest? To an embezzlement slush fund?

When you write “apply to principal,” the lender should take the extra eight dollars and reduce the amount of total debt (the principal) you owe. If they ignore your instruction (or if you fail to provide one), the lender may instead take the $8 and apply it towards your next installment. In this case, it’s as though you prepaid $8 of the $117 due next month.

Some lenders make pre-paying principal far easier than others. But in the lender’s defense, the lenders can’t know your intention without you telling them. Say you mailed in a check for $234 (double the $117 required) on March 31 without a note. While I’d hope that you were doing so to accelerate the rate at which you pay off the debt, the lender could legitimately think you had a great income in March and are a little nervous about April’s expenses and so you wanted to get both your March and April payments out of the way.

Take away any doubt and tell them what you want to do with the extra payment. Then, ask for a payment schedule or other documentation showing that the principal was reduced. Like I said, some companies will make this very easy – others make you dance through hoops. But dancing is good exercise and you should do it.

Paying more than the minimum while ensuring that the excess is applied to principal, is the most efficient combination available to paying down your debt as quickly as possible.

Thanks for the question, Beth.

Who else has done this? Did you write anything on your checks? Did you run into any obstacles? How many years did you knock off your repayment schedule?

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One Comment to “Maximizing value when paying more than the minimum”

  1. bethh says:

    Thanks for answering my question! It makes sense when you spell it out that way. Guess I wound up paying a few extra bucks on my car loan… woops. (ah well, at least that was to a small credit union)

    I’m changing my payment to Sallie Mae to the exact amount they require, and will start stashing cash to pay to the principal on a regular basis.

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