How Extra Payments Pay Off a Loan Faster, With Examples

Why extra payments work

On a standard loan the scheduled payment covers that month's interest first, and the rest reduces principal. An extra payment skips that queue: when it is applied to principal, the whole amount lowers the balance. Next month's interest is then calculated on a smaller number, so slightly more of your normal payment also goes to principal.

The effect builds on itself, in the same way that compound interest builds on a savings balance, only in your favour. Because early balances are large, extra payments made early have the most months to work and save the most.

A mortgage example

Example: a 200,000 mortgage at 6.5% over 30 years has a scheduled payment of 1,264.14 and costs about 255,086 in interest if it runs the full term. Here is what a fixed extra amount every month does, with the extra applied entirely to principal:

Adding just 100 a month, which is under 8% of the payment, removes more than five and a half years and about 55,900 in interest. The saving per extra unit is large because the extra payments begin when the balance, and so the interest, is highest.

Notice that the savings are not proportional. Doubling the extra amount from 100 to 200 does not simply double the saving, it raises it from about 55,900 to about 90,100. Each additional unit still helps, but the first units sent have the longest to work.

The same logic applies in reverse to the final years of any loan. Once the balance is small, the monthly interest is small too, so an extra payment late in the term saves much less than the same amount would have saved at the start.

Three ways to pay extra

A regular monthly top-up is not the only approach. The same mortgage shows how other patterns compare:

• One extra payment a year. Paying one additional full payment a year is about 105.35 extra per month on average. It finishes in 292 months, about 24 years 4 months, and saves roughly 56,000, similar to adding 100 a month.
• A one-off lump sum. Adding 5,000 after the first year, with no other change, ends the loan after 336 months, which is 28 years, and saves about 25,600 in interest.
• Rounding up. Rounding each payment up to a neat figure, such as 1,264.14 to 1,300, is painless and adds about 36 a month. It ends the loan after 332 months, about 27 years 8 months, and saves roughly 23,900.

Which pattern suits you depends on cash flow. A small regular amount is easier to sustain, while a lump sum is useful when you receive a bonus or tax refund. Mixing both is also common.

A shorter loan, a smaller saving

The effect is smaller on shorter loans because there is less time for interest to build. Take a 20,000 car loan at 6% over 60 months, with a payment of 386.66 and about 3,199 of interest. Adding 50 a month finishes it in 53 months and saves about 429. Adding 100 a month finishes it in 47 months and saves about 755.

The percentage saving can still be meaningful. Paying 100 extra on this loan removes roughly a quarter of the interest and over a year of payments. To test your own numbers, enter the loan terms in the loan calculator and compare the totals with and without the extra amount. For background on how balances grow, see the compound interest calculator.

Before you pay extra

• Apply it to principal. Some lenders treat extra money as an early payment of next month's instalment unless told otherwise. Check how to mark it as principal only.
• Look for prepayment penalties. Some loans charge a fee for repaying early or beyond a set amount. Read the loan terms or ask.
• Compare rates. Paying down a loan at 6.5% is similar to earning a certain 6.5% before tax on that money. Debts with higher rates, such as credit cards, are usually the better target first.
• Keep a cash buffer. Money sent to a loan generally cannot be taken back, so keep enough accessible for emergencies.

This article is general education and not financial advice. Whether extra payments suit you depends on your loan terms, other debts, savings and goals, so consider speaking to a qualified adviser.