Extra payments: paying off a loan sooner

An extra payment is money you put into the loan on top of the normal monthly payment, and it is booked against the balance. That is where expectations part company with the mechanics: the monthly payment does not move. It stays at the figure in the agreement and keeps being collected as before. What gets shorter is the term. With a lower balance after the extra payment, fewer payments are needed to clear it, and the final date moves closer. A bank can also book the money the other way, lowering the payment and leaving the term where it was. That is a different decision with a different result: the payment gets easier while interest keeps running for the full agreed term. The difference is not a formality, it decides whether you save months or only pay less each month. Which of the two happens depends on what you state when you pay. Say nothing and the bank applies its own terms, and you find out from the next statement.

The same amount does more early on

Interest runs on the balance. While the balance is high, a lot of interest builds every month, and a large slice of each payment goes to it without making the debt smaller. Late in the term the balance is small, the interest slice is thin, and nearly all of the payment reduces the debt. So the same amount does different work depending on where in the term it lands. What counts is the balance the bank still carries today. An extra payment in the second year takes away the interest that this amount would have generated in every month still to come. The same payment in the final year takes away only the interest of the few months that are left. No bonus for paying early is involved, only the time over which the removed amount would otherwise have carried interest. A late extra payment is not wasted either, it still brings the last payment forward. The interest effect is simply smaller. How far apart early and late sit at your rate depends on your own figures, and those are in your agreement.

Getting the money onto the principal

In the United States the obstacle is rarely permission, it is bookkeeping. Send a lender more than the amount due and there are several things it can do with the surplus, and only one of them shortens the loan. Which one happens follows the instruction attached to the payment, and where no instruction is attached it follows whatever the lender does by default.

Applied to principal

The balance drops on the day it posts, the interest charged from then on is smaller, and the term gets shorter. This is the outcome worth insisting on.

Paid ahead

The surplus counts as your next payment. The due date moves out, the balance stays where it was, and interest keeps running as before.

Spread across instalments

The surplus is divided over payments still to come. That lowers what you owe each month instead of shortening the loan.

Two clauses in the agreement decide whether the arithmetic works at all. The first is a prepayment penalty, a charge for paying ahead of schedule: it is disclosed rather than forbidden, so whether you have one is a question about your own paperwork. The second is how interest is calculated. On a simple-interest loan interest accrues on the outstanding balance, so a smaller balance means less interest from that day on. Where the interest for the whole term was precomputed and built into the total, paying early does not remove all of it, and whatever rebate you get is governed by the contract.

In Germany the right comes from the statute, not the contract

People search the credit agreement for a clause that allows extra payments and read the absence of one as a ban. For an ordinary consumer loan in Germany that reading is wrong. § 500 (2) BGB, in the German Civil Code, says: „Der Darlehensnehmer kann seine Verbindlichkeiten aus einem Verbraucherdarlehensvertrag jederzeit ganz oder teilweise vorzeitig erfüllen." A borrower may settle a consumer credit agreement early at any time, in part or in full. The right comes from the statute, so it does not have to appear in the contract, and an annual cap on extra payments written into the agreement changes nothing, because § 500 (2) BGB attaches no ceiling to the right. Both cases are covered: the part payment, called a Sondertilgung in German, and paying the loan off completely. One restriction applies to a residential mortgage loan with a fixed borrowing rate, an Immobiliar-Verbraucherdarlehen. While the rate is fixed, early repayment there requires a legitimate interest, the sale of the property for instance. A car loan or a refinancing is not caught by that. How the bank handles the payment in practice, the date on which it books it for instance, is in your contract terms. This describes the statute and is not legal advice.

What the bank may charge

A bank may ask for compensation for early repayment, the Vorfälligkeitsentschädigung. For an Allgemein-Verbraucherdarlehensvertrag, the ordinary consumer loan, § 502 BGB caps how high that compensation may go. It is measured against the amount repaid early, and the cap drops when the agreed repayment date is close anyway. A second cap sits beside it: the compensation may not exceed the interest you would still have paid between the early repayment and the agreed one. Read the percentages as a statutory ceiling and not as a price, because what your bank puts on the table can be lower or nothing at all, and the figure comes back in its reply to your request. § 502 BGB names two cases in which the claim is excluded. The first: the repayment is made from an insurance taken out under an obligation in the loan agreement to secure repayment. The second: the statements in the agreement on the term, on the right of termination of the borrower, or on the calculation of the compensation are insufficient. Where compensation is charged, those statements in the contract are the first thing to check.

Ordinary consumer loan

At most 1 percent of the amount repaid early, § 502 BGB.

Within a year of the agreed repayment

At most 0.5 percent, where the period between the early and the agreed repayment does not exceed one year.

When the money is better used elsewhere

• With no savings behind you: an extra payment is gone and does not come back. If the washing machine dies next month, you may end up borrowing for the replacement at a rate you did not choose. A buffer for running costs comes first.
• With a dearer debt somewhere else: interest runs on every open balance at the same time. A dollar does the most work where the rate is highest. On an overdraft or a credit card on minimum payments, that rate often sits above the rate on a loan.
• With anything overdue: late fees and collection costs land in one step rather than accruing slowly like interest. An item close to that stage goes before any extra payment.
• When the next payment is shaky: if it is unclear whether the normal monthly payment will clear, the money belongs there. A failed payment costs fees, a skipped extra payment costs nothing. If it is going to be tight, a word with the bank before the date costs less than a failed direct debit after it.

Prepayment penalties, Consumer Financial Protection BureauWhat a prepayment penalty is, which loans carry one and where it has to be disclosed. The starting point for checking your own agreement before you pay ahead of schedule.

§ 500 BGB, Gesetze im InternetThe official German wording on termination and early repayment. Paragraph 2 sentence 1 carries the right to repay early, sentence 2 the restriction for a residential mortgage loan with a fixed borrowing rate.

§ 502 BGB, Gesetze im InternetThe official German wording on compensation for early repayment. The grounds for exclusion are in paragraph 2, the ceilings of 1 percent and 0.5 percent in paragraph 3.