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Is it Better to Pay Extra Principal Monthly or Yearly?

Published in Loan Principal Payments 4 mins read

Paying extra principal monthly is generally more advantageous than making a single large yearly payment. This approach allows you to save more on interest over the life of your loan and offers greater flexibility for your budget.

When you contribute extra principal each month, even a small amount, it immediately reduces the principal balance. This means that for every subsequent payment, a slightly larger portion goes towards principal and a smaller portion towards interest, as interest is calculated on the remaining balance. Over time, these small, consistent payments compound, leading to significant savings and a shorter loan term.

Why Monthly Payments Are More Effective

The power of compounding interest works in your favor when you pay more frequently. Here's a breakdown of the benefits:

  • Accelerated Interest Savings: By reducing your principal balance sooner, you reduce the amount of interest that accrues on your loan from that point forward. With yearly payments, the larger principal balance remains for most of the year, allowing more interest to accumulate before the extra payment is applied.
  • Shorter Loan Term: Each extra dollar you pay toward principal directly shaves time off your loan. Consistent monthly extra payments can lead to a substantial reduction in your overall loan term, helping you become debt-free much faster.
  • Budget-Friendly Approach: Many find it easier to incorporate a small extra amount into their monthly budget rather than saving up a large lump sum for a yearly payment. For instance, if your mortgage payment is $900, paying an additional $75 each month (which is 1/12th of an extra payment) means you've effectively made an extra payment by the end of the year without a significant financial strain at any single point.
  • Increased Flexibility: If an unexpected expense arises, it's simpler to temporarily pause or reduce a small monthly extra payment than to defer a large annual payment you've been saving for.

Monthly vs. Yearly Principal Payments: A Comparison

Feature Monthly Extra Principal Payment Yearly Extra Principal Payment
Interest Savings Higher due to more frequent principal reduction. Lower, as the principal remains higher for longer.
Loan Term Significantly shortened through consistent, early principal reduction. Shortened, but less effectively than monthly payments.
Budget Impact Easier to manage; small, regular additions. Requires saving a larger lump sum; potential for financial strain.
Compounding Benefits from compounding interest reduction immediately. Delays the benefit of principal reduction for most of the year.
Flexibility Easier to adjust or pause if financial circumstances change. Less flexible; a missed lump sum payment means losing a year's benefit.

Practical Ways to Pay Extra Principal Monthly

You don't need to make a massive additional payment to see results. Small, consistent efforts can add up significantly.

  • Divide Your Payment: One common strategy is to pay an extra 1/12th of your regular monthly payment. For example, if your mortgage payment is $1,200, paying an extra $100 ($1,200/12) each month means you effectively make an extra payment each year, dramatically reducing your loan term and total interest paid.
  • Bi-Weekly Payments: Another effective method is to switch to bi-weekly payments. By paying half your monthly amount every two weeks, you'll make 26 half-payments over the year, which equates to 13 full monthly payments instead of 12. This automatically builds in an extra payment each year.
  • Round Up Your Payment: Simply round up your monthly payment to the nearest $50 or $100.
  • Allocate Windfalls: If you receive a bonus, tax refund, or inheritance, consider dedicating a portion of it as an extra principal payment, especially at the beginning of the year to maximize interest savings.

Ultimately, any extra payment toward your principal is beneficial, but the consistent, incremental approach of monthly payments yields superior long-term savings and provides a more manageable financial strategy. For more details on how extra payments impact your loan, you can explore resources on mortgage amortization.