Are You Paying Off Your Debt Wrong?

It’s happened. You’ve pinched all your pennies, paid off all your bills and — finally! — ended up with enough money to make an extra loan payment this month. But when you queue up the online account, you’re hit with an unexpected question: do you want to make a prepayment toward your next monthly bill or pay off some of your principal?

What’s the Difference?

Prepayment options generally apply to installment loans, like an auto loan or mortgage, where you make a set payment at a specific interest rate over a specified period of time. They don’t really come into play when you’re dealing with revolving debt like a credit card, where interest gets recalculated each month and your best bet is to pay down any balances as soon as possible.

When you elect to pay ahead, you’re allocating the funds toward future monthly payments. Accelerating your monthly payments could reduce the amount of time it takes you to pay off your loan, so long as you don’t skip future payments, Thomas Nitzsche, media relations manager for ClearPoint Credit Counseling Solutions, said over email, but depending on the terms of your loan, it may not reduce the amount of interest you pay.

Paying down your principal (the amount that is left on your loan plus any interest), on the other hand, reduces the amount of time it’ll take you to pay off the loan and the amount of interest being charged, but you’ll still be required to make next month’s payment.

“Your [monthly] payment will never change making an extra principal payment,” Scott Sheldon, a senior loan officer at Sonoma County Mortgages and a Credit.com contributor, said.

Deciding What to Do

Making a prepayment can be the right move if your income isn’t stable. For instance, it could help freelancers or contractors “because it can allow them to absorb lean times in their budget by ‘skipping’ future payment if/when necessary,” Nitzsche said over email.

In most other scenarios, paying down your principal is likely the best way to go.

“In general, if the consumer has the ability to pay more on a loan, is a [salaried] employee, has sufficient emergency savings and is accomplishing other long-term goals such as retirement/college savings, we would recommend they make extra principal payments towards the loan, assuming it doesn’t have any prepayment penalties,” Nitzsche said. “This allows them to reduce the amount of interest paid, the duration of the term and to move on to other goals sooner.”

Of course, you’ll have to carefully review the terms and conditions of your mortgage to be sure what option is right for you. You’ll want to be aware of any fees associated with paying your mortgage off early. And when it comes to making an extra payment, you’ll need to check if your servicer imposes any contractual or technological restrictions regarding either option.

For instance, “some lenders default to using extra payment to pay future interest rather than principal and require you to call each month to direct the payment to principal instead,” Nitzche said. “Others only allow you to pre-pay a certain number of months ahead.”

Consider All Your Options

Remember, you don’t have to put that extra money toward your loan. And, in fact, there are certain situations where you probably shouldn’t — like, say, if your savings account is running on empty, your retirement funds are virtually non-existent or you’re hoping for a hefty tax deduction from your mortgage interest.

Refinancing could be another way to save on the interest you’re paying on your home. (Just be sure to check your credit before you shop around since a good credit score generally entitles you to the best terms and conditions. You can check your credit scores for free each month on Credit.com.)

There are also other alternatives consider. For instance, if your main concern is missing a mortgage payment, you can open up a checking account specifically for them and set up automatic monthly payments to come from it, mortgage pro Sheldon said.

Or “open a savings account,” says Jorie Johnson, a certified financial planner based in Brielle, N.J. “Put [any extra money] in there and when the amount … equals the principal owed, mail it in and pay down the entire balance of the loan.”

This plan could ultimately accomplish what you initially set out to do — getting that pesky loan off the books earlier and cheaper than expected — but also provide you a certain amount of flexibility, should your financial situation abruptly change, Johnson said.

“If you have an emergency, you have access to that money,” she said. “Hold on to your money and make it work for you.”