It is really interesting to see the results of making an extra payment to a mortgage, auto loan, or any other amortized loan. I think there is some confusion as to what exactly happens, mathematically, when you make the extra payment. To understand what happens when you make an extra payment you first have to know if you have an amortized loan. The definition of an amortized loan is “a loan with scheduled periodic payments of both principal and interest. This is opposed to loans with interest-only payment features, balloon payment features and even negatively amortizing payment features.”
An Example Amortization Table
For our example I am going to use a very common auto loan:
- $20,000 Car Purchase
- 60 Month Pay off
- 5% Interest Rate
This gives us a payment of $377.42/month, however, each payment will be made up of differing principal and interest amounts.
Your payment doesn’t change but the interest per month goes from $83 in the first month to $1.57 and the principal payments go from $294 to $376 (you may have to click the pictures to zoom in).
Adding an Extra Payment to an Amortized Loan
Now let’s add an extra $50/month to our payments. As I learned the hard way you may have to tell your auto financing or mortgage company that you wanted any extra payments added to the principal (a long time ago I had a problem with my extra auto loan payments going to future payments rather than going to principal).
You may have to zoom in to see the numbers clearly, but what is happening is that all those extra payments are going to the later payments effectively erasing those later interest payments. That is the reason why bloggers and pundits say prepaying debt is like getting a guaranteed return.
In the above example paying an extra $50 saves 7 months of payments and $352 in interest payments.