Paying loans early - differences between types of loans

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dm200
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Paying loans early - differences between types of loans

Post by dm200 »

In various posts, there has been a considerable amount of confusing and incorrect information posted about the deatils of paying loans early. I am involved in the details part of consumer loans (credit union) and will give some examples of prepaying or paying a credit union consumer loan early. Since there are several ways of calculating interest on loans (including how leap year is considered), the exact details may differ by small amounts. Bank and auto finance loans are probably very similar, but may not be identical.

As an example, take a $10,000.00 credit union loan at 6.00% interest rate for 48 months issued 1/15/12 with 1st payment due 2/15/12 and the 15th of succeeding months. The monthly payment would be $234.86 per month for 47 payments and a final payment of $234.71 and an approximate total interest of $1.273.13. The exact amount of interest depends on the exact amount paid and which day the payment is credited. Such consumer loanscharge interest on the number of days and the utstanding balance each day.

On this loan, suppose you paid the $234.86 on the 10th of every month (5 days early). Because this would slightly reduce the balance each month on the principal, overall interest would be less, resulting in a final (48th) payment of 224.31 - a savings of about $10.

As another example, suppose you chose to pay a little extra each month on the 15th. Say you paid $250.00 each month on the 15th. You would then pay off the loan with 44 payments of $250.00 and a 45th and final payment of $185.43. Total interst would be 1,185.43.

If you pay extra, do you still need to make the full monthly payment the next month? If you read al the fine print in the loan agreement, almost certainly the full payment is required each month. However, most credit unions - to some degree - allow paying early or extra to then allow skipping a month''s payment. So, for example, if you make three payments in July, can you then skip August, September and October?? Maybe or maybe not - all depends on the policies and practices of that credit union. Some credit unions will allow 1, 2 or 3 months prepayment where you can then skip.

While mortgage loans could operate the same way, almost none do. Mortgages operate with somewhat different rules, practices and customs. Mortgages are almost always sold by the issuing credit union (or bank) or, if not actually sold, structured in a way where they could be sold. In almost all cases, interest is collected based on the amourtization schedule - not actual days. So, for example, my mortgage payment is due the 1st of the month. BUT - whether I pay my January 1 due payment on December 25 (early) or january 10 (late, but within the grace period) - the interest paid is the same. For mortgages, if you want to pay extra to save interest, that must be specifically identified and credited according to the rules of the lender/servicer. When you pay extra and/or early to save interest, you still owe the full payment in succeeding months. One reason for mortgage loans being treated like this is that it better allows transfers and sale of mortgages from one institution to another that have very different data processing and crediting systems in place.
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Re: Paying loans early - differences bewteen types of loans

Post by LadyGeek »

Excellent points, they're now in the wiki. Do you have any corrections or suggestions?

Wiki article link: Paying down loans versus investing

Could you elaborate how you arrived at the solutions for your three examples?
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Re: Paying loans early - differences bewteen types of loans

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LadyGeek wrote:Excellent points, they're now in the wiki. Do you have any corrections or suggestions?

Wiki article link: Paying down loans versus investing

Could you elaborate how you arrived at the solutions for your three examples?
I used the loan calculator (for an actual credit union) that is used to calculate/disclose information about what an actual borrower would get for the first calculation. The nuts and bolts of this would be for a loan that uses a 365 day year for interest calculations (actual days in a year) EXCEPT that a 365 day factor (rate divided by 365) is used for 366 days in a leap year (allowed by regs). This assumes no processing fees or any other fee on the loan.

For the second example (paying the payment 5 days early each month), I used that dame calculator plugging in the monthly payment from the first example, but with the monthly payment due on the 10th of each month. Then "solve" for number of months. There are still the same 48 payments, but the last one is about $10 less.

The third example is that same loan calculator using the due date of the 15th of the month, but with the $250 payment - then - solve for number of months and that calculator gives the fewer number of months.
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Re: Paying loans early - differences bewteen types of loans

Post by LadyGeek »

Thanks. I wanted to be sure on the "nuts and bolts" as it's important to understand how the information was derived. Interest is calculated on a daily basis, no additional fees, and a 365 day count convention.

(An easy-to-understand daily interest example is shown in Help! Need to Calculate Money Owed To Me.)
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Re: Paying loans early - differences bewteen types of loans

Post by dm200 »

LadyGeek wrote:Thanks. I wanted to be sure on the "nuts and bolts" as it's important to understand how the information was derived. Interest is calculated on a daily basis, no additional fees, and a 365 day count convention.

(An easy-to-understand daily interest example is shown in Help! Need to Calculate Money Owed To Me.)
If this loan (10,000 48 months issued 1/15/12 1st pmt due 2/15/12 and pmt of 234.86) used a 366 day factor in leap years, that would change the monthly payment to 234.83 with a final payment of 234.48 and total interest of 1271.49.

Likewise a 360 day year and counting all months as 30 days with daily interest calculations would make a few cents difference in total interest, depending on the month the loan was issued and schedule of months of repayment. However, all of these methods come within very small differences and all are 100% in compliance with laws and regulations.
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