As you pay off a large bill, you may notice that your balance isn’t getting smaller as quickly as you thought it would. For example, on a $2,000 loan, you’ve made $500 in payments, but your balance due is still more than $1,500. Why? The short answer is that it has to do with the type of loan and how the interest on your balance is calculated.
For some types of loans, at the beginning of the loan term, the majority of each payment goes towards interest rather than the principal (the amount you borrowed). Over time, that changes and more of your payment goes towards the principal, so you’ll see your balance go down more quickly.
Loans can have a fixed interest rate or a variable interest rate. A fixed rate does not change over the life of the loan, so your payments remain the same. A variable rate may change over time as an index rate, such as the prime rate, changes. With a variable rate, your payments can get larger or smaller depending on changes in the interest rate.
There are two kinds of interest: simple and compound. Many fixed rate installment loans use daily simple interest. That means that interest accrues on a daily basis on the amount of the loan (your current outstanding principal balance) from the date the interest charges begin until you repay the loan. You pay interest on the principal balance or the amount of money you borrow.
Compound interest, the kind of interest charged on lines of credit and credit cards, is different. As long as your line of credit has more than a $0 balance, you’ll be charged interest on the total balance. Each month, interest will be calculated on your previous unpaid balance + interest on that balance + any new withdrawals you make from the line of credit.
Take control and get in front of debt
The best way to stay on top of your debt is to always make your payments on time and in full. That will help you pay off your debt more quickly and save a lot of money in interest charges. Try these tips to get a handle on your debt:
- Catch up and keep up - If you get behind on your loan payments, make all your past due payments as quickly as you can. If possible, make multiple payments at once. You should also make the current new payment due each month to keep your balance from growing.
- Pay more than the minimum - Even paying a little more than the minimum due can make a debt disappear more quickly. Paying more means that you’ll owe less in total interest charges in the future.
- Make more frequent or larger payments - Talk to your lender about whether it’s possible for you to make more than one payment a month or pay more than your scheduled payment. When you have extra money in your budget, make two payments rather than one or add extra money to your regular payment.
- Revise your budget to free up more money for loan payments - Make a new budget and look for places where you can cut expenses. Consider bringing lunch to work rather than going out, carpooling to save on gas, or having movie night at home. Put all the money you save towards your loan payments.
- Consider your savings - We know it’s important to save money for emergencies and unexpected expenses. However, if you can afford it, you may want to use some of your savings to pay off debt, particularly bills with high interest rates.
Paying down debt is a smart move, so make a plan that helps you achieve your goal and stay on track. It’s the first step on the road to a brighter financial future.