Finance 301: Pay Less Interest By Overpaying

Dollar rollIf you want more of your money in your pockets over time pay more money upfront. Sounds counter intuitive I know. The interest rate on your loan, if it’s fixed, will not change, unless you refinance of course. Your monthly payment will go toward interest and paying down the principle. If you have $1000 loan with 10% interest you will be charged the $100 plus $40 toward principle giving you a monthly payment of $140. Interest is charged on the outstanding balance of the loan. So instead of paying the $140, pay $200. The extra $60 dollars go towards the principle. The next month the 10% will be charged on $900 (interest = $90) instead of $960 (interest = $96). Over the life of the loan reducing the balance faster than the schedule will result in less interest paid over the life of the loan.

This is an overly simplified example of how this works. But this is the premise. This works on any type of loan – student, mortgage, credit cards, etc. This is more money out of your pocket on the front end however. Depending on your interest rate you could be saving thousands of dollars over the life of the loan.

Let’s use a student loan as an example. The current federal loan rate is about 3%. If you take out a $10,000 loan with a 20 year term (has to be paid by October, 2033) the monthly payment would be $56. The interest paid over 20 years would be $3,310. If you add an additional $100 per month to that payment or $156 the interest paid over the life of the loan would be $915 AND the loan would be paid off by September, 2019…14 years sooner! It’s worth the sacrifice on the front end to create a long term savings of $2,395. Plus you don’t have the monthly payment hanging over your head for 20 years.

If you can’t swing making an extra payment every month that’s okay. Make it when you can. Every other month or if you need to take a month or two off do that. You will still benefit from the over payment.

What can you do with the “extra” money. So in 2019 when you’ve paid off that school loan, take the $156 a month and put it toward another debt to accelerate paying off the balance. The priority is to focus on accelerating the payoff of your higher interest debts. With a school loan being so low in interest overpay a credit card. Then once it’s paid off, roll that monthly payment into the minimum monthly payment of another debt. Pretty soon, you’ll be all done. Look to see where you can make short term sacrifices, as you see they make a big difference down the road.


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