You don’t always have to play by a lender’s rules.
- Additional payments are not always applied to the principal of the loan.
- Compound interest means you pay interest on interest.
- It’s up to you to call the lenders to find out how to apply the funds directly to the principal.
Tori Dunlap, an internationally renowned money expert, has her work cut out for her with lenders of all shapes and sizes. This involves how difficult it is for lenders to make it difficult for borrowers to prepay debt. Fortunately, on her financial feminist podcast, Dunlap also offers tips for outsmarting sneaky lenders.
Understand the basics
while writing his book financial feminist, Dunlap found that some women didn’t fully understand how a loan worked. In fact, it was the main reason given by women for going into debt or going into more debt.
Although Dunlap didn’t say so, it’s safe to assume that many people, regardless of gender, don’t know exactly how the loans work. We have a “rough idea” but don’t always understand the details included in the loan agreements we sign.
The simple stuff
Most people understand that there are two parts to a loan: principal and interest. Let’s say you take out a $20,000 loan at 9% interest. Principal refers to the $20,000 that ends up in your Bank account (or covering the cost of something you bought), and interest is the amount you have to pay the lender to borrow money. A large portion of each payment (especially in the first few months or years of the loan) is used to pay interest, and little to reduce the amount of principal you owe.
Where things get a little confusing
Most loans include compound interest. Here’s what that means: In addition to paying the 9% interest you agreed to pay when you borrowed the $20,000, you must pay interest on 9% interest. It’s true. Lenders charge interest on the interest you already pay as if it were part of the principal.
Compound interest is a thing of beauty when you earn on investmentsbut it’s pretty stinky when you’re trying to get out of debt.
You must love Dunlap for quoting Albert Einstein here. Einstein is reported to have said, “Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t…pays for it.”
How Lenders Can Be Downright Sneaky
According to Dunlap (and everyone in the free world), corporations are there to make a profit. “So they’re going to do everything they can to help them make more money. That includes making it harder or harder to pay off your loan sooner.”
Let’s say you have a Personal loan or a car loan that you would like to prepay. You send an extra $100 every month, believing the funds are paying off the principal. However, the company does not apply this money to the principal at all. Instead, they apply it to the next month’s payment or apply part to principal and part to interest.
It might not seem like a big deal, but as Dunlap says, “Instead of just putting extra money into the loan in general, you want to contribute all the extra money you have to the principal of that loan.” If you repay the principal, you will ultimately pay less interest.
Dunlop tells an interesting story of a time when she wanted to pay for her car early. Every month she would send an extra $50 to Toyota. After realizing that the company was not applying the funds to the principal, she went to Toyota’s website. The automaker didn’t want to make it easy, and its website gave no instructions for making principal-only payments.
When she called customer service, Dunlap said she had spent 20 minutes on hold, only to be told that if she wanted to make contributions to the principal, she should send money to a random PO box in Iowa. She only knew because she called and asked.
Businesses know that most people won’t bother to call and ask.
And that’s where Dunlap’s plan comes in. She says if you have extra money to put in to pay off a loan sooner, call the lender. It doesn’t matter if it’s a credit card company, mortgage lender, or another type of lender. Call before sending extra money. Make sure you know the lender’s process for directly repaying the principal.
Dunlap’s message bears repeating: “Corporations aren’t there to help you. They’re there to put you in debt because it makes them money.”
Fortunately, once you figure out how to focus on paying principal, it’s in your power to reduce it.
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