Why small payments can have a small impact on your loan balance

Imagine this: It’s time to pay your credit card bill and money is tight, so you choose to simply pay the minimum payment. A few days later, you check your credit card account again only to see the amount you owe on that card barely went down. But how can that be after just making a payment? The answer lies in how interest works. Learn why making small loan payments often have a small impact on your loan balance.

What you’ll learn:

• What is interest?
• How is interest calculated?
• How interest impacts your principal
• Why small payments barely pay down your balance
• How to pay down your balance effectively

What is interest?

Simply put, interest is the cost of borrowing money. If someone loans you money, interest is a way for them to account for both the risk they take on in case you don’t pay them back as well as the inconvenience of not having access to that money in the meantime. Interest is often talked about in terms of an interest rate, which is the percentage of a loan’s principal charged by the lender.

How is interest calculated?

There are multiple ways to calculate interest, but this can generally be reduced to two main categories: simple interest and compound interest.

Simple interest, as the name implies, is the simpler of the two. Here, the interest rate applies only to the principal. Many types of loans are based off of simple interest, such as many personal loans, mortgages, student loans and more.

Compound interest, on the other hand, calculates interest by the total of the principal plus accrued interest. This results in a compounding effect, where the total interest can snowball relatively quickly. This can work both in your favor and to your detriment. In a high-yield savings account, compound interest is fantastic for you, as you can earn the same rate on your deposited interest as your initial deposit. However, if you have a loan with compound interest, your loan balance can quickly grow if you don’t pay it off aggressively enough.

How interest impacts your principal

Understanding the relationship between interest and principal is essential to make the most of your money. In some types of loans, such as auto loans and mortgages, you typically agree to a set payment schedule as part of the loan. For example, a 30-year fixed mortgage will have a consistent principal and interest monthly payment across those 30 years until your loan is paid off (except in the case of escrows).

However, in these types of loans, your early payments mostly go toward interest while later payments mostly go toward principal, even though the payment itself remains consistent. This is known as amortization. By making additional payments to the principal on top of your loan payment schedule, you can reduce the interest owed and get a head start on reducing the principal balance, thus reducing future interest owed in the process.

Why small payments barely pay off your balance

Other types of loans do not have a predictable payment schedule, such as a credit card. These are known as non-amortizing loans. While you likely have a monthly minimum payment for your credit card, this number is often relatively low and the amount you choose to pay every month will vary based on your spending and ability to pay.

The risk of non-amortizing loans is that you do not have a fixed schedule that ends in the loan being paid in full. With a credit card, you can choose to pay the minimum payment, which will likely primarily go towards interest rather than principal. You still have most of the original principal, plus you may spend even more over the following month, resulting in a larger balance owed and higher monthly minimum payment, which will still mostly be applied to interest.

This can easily turn into a snowball effect, where payments at or near the minimum continue to go primarily to interest while the overall balance continues to accumulate. The risk is that your loan balance could grow to a level where you can only afford to make payments near the minimum, resulting in an extremely long timeframe to pay off the balance in full, even without additional spending.

How to pay down your loan balance effectively

To avoid making small payments that barely move the needle on your overall loan balance, there are several strategies and steps you can take. First, set a budget to ensure your spending is within your means. This is foundational to know where your money is going and get a full picture of your expenses.

Next, for loans without a fixed payment schedule like credit cards, know that the minimum monthly payment will have minimal impact on the principal balance. Paying the full statement balance or close to it will result in all or most of your money going towards the principal instead.

Finally, if you find yourself in a situation where you are struggling to pay down a loan balance, explore whether debt consolidation is an option. This works by taking your existing debt and effectively transferring it into a new account with more favorable terms. If you have several high-interest credit cards you owe on, you may be able to get a limited-time 0% APR offer that would allow you to apply payments directly to the principal.

As frustrating as it can be, knowing smaller payments can barely move the needle on some loans, understanding why it is critical for financial success. Knowing what type of loans this is applicable to and the strategies to combat it will help you avoid long-term high-interest debt and make smart financial decisions.