When you secure a loan, monthly payments typically reduce both the balance and accumulated interest. Most borrowers expect their total loan balance to decrease steadily over time.
However, many borrowers discover their loan balance actually increases over time. Why does this occur, and how can you prevent this situation?
We’ll explore what drives loan balance increases, effective prevention strategies, and actionable solutions.
Types of Loans
This guide explains why loan balances increase and provides strategies to manage the situation. First, let’s examine loan types, principal, and interest mechanics. Understanding these fundamentals will clarify the factors affecting your loan balance.
Loans fall into four main categories:
- Secured loan – Uses an asset as collateral that the lender can seize if the loan isn’t repaid
- Unsecured loan – Requires no collateral and typically carries higher interest rates to offset additional lender risk
- Installment loan – Repaid through fixed payments over a predetermined period
- Revolving credit– Allows borrowing up to a set credit limit; unpaid balances carry over to subsequent billing cycles
Loans feature either fixed or variable rates. Fixed-rate loans maintain consistent interest throughout the loan term, while variable rates fluctuate over time.
Here are the most common loan types for borrowers:
Auto Loans
Auto loans finance vehicle purchases minus the down payment. These secured loans use the car as collateral, with terms typically ranging from 36 to 72 months.
Student Loans
Student loans help students and parents finance college education. Funding comes from federal government programs and private lenders including banks and credit unions.
Federal student loans typically offer superior terms compared to private alternatives, including loan forgiveness programs, deferment options, forbearance, and income-based repayment plans.
Personal Loans
Personal loans provide flexible financing for various purposes: emergency medical expenses, home improvements, weddings, and repair costs.
These unsecured loans offer fixed or variable rates with repayment terms spanning several months to multiple years.
Mortgage Loans
Mortgage loans finance home purchases minus the down payment. The property serves as collateral and faces foreclosure if payments are consistently missed.
Mortgage terms typically span 10, 15, 20, or 30 years. Government agencies back certain mortgage programs to help borrowers qualify.
Home Equity Loans
Home equity lines of credit (HELOC) allow borrowing against built-up home equity for any purpose.
Home equity loans provide lump-sum installments with regular monthly payments over five or more years. HELOCs function as revolving credit, allowing draws as needed.
Payday Loans
Avoid these short-term loans. Payday loan fees can exceed 400% annual percentage rate (APR) and require repayment by your next paycheck.
Loan amounts typically range from $50 to $1,000. While credit checks aren’t required, these loans prove easy to obtain but difficult to repay.
What is your Loan Principal?
The principal represents the amount you’re borrowing from the lender. Loan repayments cover both principal and interest charges.
Payment allocation between principal and interest shifts over time. Interest receives priority, but decreasing principal balances result in lower interest charges.
Many lenders permit extra principal payments. Confirm this option with your lender before making additional payments.
How Loan Interest Works
Lenders provide loans at agreed-upon interest rates and terms. Interest represents the cost of borrowing money from the lender.
Interest rates calculate as a percentage of the unpaid principal balance.
Interest appears as the annual percentage rate (APR), incorporating interest and loan fees. Credit cards exclude these fees from APR calculations.
Interest application varies by credit type and lender. Simple interest and compound interest represent the two primary interest structures.
Simple interest applies only to your principal balance. Daily interest accrual uses the rate and principal for calculations.
Compound interest includes interest on both principal and previously accrued interest. Daily interest compounds increase your overall balance.
Interest application differs by loan type. Installment loans like mortgages, auto, student, and personal loans incorporate interest into monthly payments.
Conversely, credit cards waive interest charges when balances are paid by the due date.
What Increases your Total Loan Balance?
Several factors can cause loan balance increases. Below, we’ll examine these reasons in detail.
Capitalized Interest
Interest capitalization increases your total loan value. Let’s examine how this affects your loan through an example.
Suppose you borrowed $5,000 in student loans for your first college year. You’re deferring payments until six months after graduation. Interest charges will accrue for 54 months if you graduate in four years.
Your 6% student loan interest rate generates approximately $25 monthly interest. This adds $1,350 in unpaid interest to your outstanding balance over 54 months.
Your outstanding principal balance becomes $6,350.
To prevent this scenario, make monthly interest payments as they accrue. Covering monthly interest keeps your total loan balance at the original $5,000.
You have a certain type of student loan or repayment plan
If student loans show increasing balances, the loan type is likely responsible. Unsubsidized federal student loans, income-driven repayment plans, and extended plans can create this situation.
Unsubsidized student loan
Unsubsidized loans make you responsible for interest from disbursement. When repayment begins, you must repay the original borrowed amount plus all accrued interest since disbursement.
Waiting until after your six-month grace period to begin repayment will show an increased balance. That $30,000 loan becomes $34,834.
Income driven repayment plans
Traditional loan repayment amortizes your balance over the loan term. Monthly payments cover accrued interest since the last payment, with remaining funds reducing the principal balance.
Income-driven repayment plans calculate monthly payments as a percentage of your discretionary income.
Factors including interest rate, total loan balance, and income-driven payment amounts may result in insufficient coverage of monthly accrued interest.
This actually increases your loan balance and total loan cost on income-based repayment plans.
An Extended Payment Plan
Extended payment plans span 20 years or more. Total loan balances decrease over time but much slower than other options.
Repaying student loans over extended periods significantly increases total interest costs. The benefit is lower regular payments.
Timely payments become critical on these plans. One missed payment leads to higher loan balances since you’re paying less toward monthly interest.
Making Monthly Payments of less than the Requested Amount
Insufficient monthly payments can increase your loan balance due to capitalized interest.
Payments must cover both principal and capitalized interest. Otherwise, unpaid interest gets added to your total loan balance.
Deferring or Missing Payments
Forbearance temporarily suspends payments. Interest capitalization occurs during this period, resulting in higher loan balances.
When you’re not making the requested monthly payment, unpaid interest accrues and increases your total loan balance.
How to Lower your Loan Balance
Ideally, you’ll avoid situations where outstanding principal increases. Here are tactics to help prevent this scenario.
Make More Frequent Payments
Ask your lender about making multiple monthly payments. If your budget allows, making bi-monthly payments can accelerate loan balance reduction.
Get a lower Interest Rate
Seek loan options that reduce interest rates to make your debt more manageable. Consider fixed-rate loans if you currently have a variable rate for greater consistency.
Homeowners might use home equity loans to secure lower rates.
Comparing multiple loan options may seem overwhelming, but loan marketplace sites like AmOne and Credible simplify the process. These platforms gather your loan requirements and match you with suitable options.
Borrow less Money
Limiting borrowing amounts helps avoid problematic situations. Look for ways to reduce financing needs.
For example, when shopping for vehicles, consider less expensive models or wait to accumulate a larger down payment.
Increase your Monthly Payment
Your lender’s repayment schedule isn’t mandatory. Extra monthly payments typically reduce the unpaid principal amount.
Consult your lender first to confirm this option and ensure proper fund allocation. Mortgage lenders often provide online account options for additional principal payments.
Extra auto loan payments often advance your next monthly payment instead of reducing principal. Verify with your lender before increasing payments.
Choose Loans with Lower Rate options
Some lenders offer discounts for auto-pay setup, existing account relationships, or other qualifying factors. Ask your lender or servicer about available discount options.
Start with Your Most Expensive Loan
When repaying multiple loans, prioritize those with the highest interest rates. These loans generate the highest interest payments, costing more money and increasing balances most significantly.
If you’ve used credit cards or personal loans, these typically make the best starting point.
Ask for a Temporary Rate Reduction
Your lender might agree to a temporary rate reduction. Lower rates allow regular payments to cover larger principal portions.
Use your Savings if Necessary
Emergency savings remain important for unexpected expenses. However, if financially feasible, consider using savings to pay down loans, particularly those with higher interest rates.
