When you take out a loan, your monthly payments will typically go towards the balance and interest. One would assume that your total loan balance would go down.
However, many borrowers are surprised to see their loan balance increase over time. Why does this happen, and what can you do to avoid this situation?
We’ll discuss what increases your total loan balance, what you can do about it, and much more.
Types of Loans
In this guide, we’ll share reasons that your loan balance goes up and strategies to help you deal with it. But first, we’re going to dive deeper into types of loans, the principal, and interest. Having this foundational information will help you understand the factors that impact your loan balance.
Loans can be categorized into the following four categories:
- Secured loan – You use an asset as collateral which the lender can take if the loan isn’t repaid
- Unsecured loan – Doesn’t require collateral and tends to have higher interest rates to offset the additional risk to the lender
- Installment loan – These loans are paid back with fixed payments over a set period
- Revolving credit– Allow you to borrow up to a set credit limit; If you don’t repay what you’ve borrowed each billing cycle, that balance will carry over to the next month
Loans may have either a fixed or variable rate. On a fixed rate loan, your interest won’t change over the loan term. A variable rate loan’s interest rate could change over the loan term.
Next are the most common types of loans you may use when borrowing money:
With an auto loan, you can use it to pay for a car, less the down payment. These are secured loans where the car is the collateral. The terms on an auto loan are usually between 36 months and 72 months.
Student loans are used to help students or their parents pay for college. Loans are available through the federal government and private lenders like banks and credit unions.
Federal student loans are almost always a better choice than private loans. That’s because they offer more favorable options like loan forgiveness, deferment, forbearance, and income-based repayment plans.
Personal loans can usually be used for almost anything you want to use them for. Emergency medical expenses, home improvement projects, weddings, and covering repair cots are some examples.
These loans are unsecured and may be fixed or variable rates. The repayment terms are usually several months to a few years long.
Mortgage or home loans are used to pay for a home, less the down payment. The home is the collateral and can be foreclosed if too many payments are missed.
The loan term on a mortgage is typically 10, 15, 20, or 30 years. Some mortgage loans are backed by various government agencies to help borrowers qualify for mortgages.
Home Equity Loans
Also called home equity line of credit (HELOC), these loans allow you to borrow a percentage of the equity built up on your home. These loans can be used for any purpose.
Home equity loans are installment loans where you get a lump sum and pay it back with regular monthly payments over five or more years. Since these loans are revolving credit, you can draw from the credit line as you need.
These short-term loans should be avoided. The fees charged on payday loans be over 400% annual percentage rate (APR) and must be repaid by your next paycheck.
The loan amounts are usually for small amounts like $50 to $1,000. Since they don’t require a credit check, these loans are easy to get, but hard to pay back.
What is your Loan Principal?
When you take out a loan, the principal is the amount of money that you’re borrowing from the lender. When you repay a loan, your payments will go towards paying back the principal and interest.
How much of your payment goes toward the principal and interest will change over time. Interest always gets paid first, but as your principal goes down, there is less interest.
Some lenders will allow you to apply extra payments towards the principal. Make sure you ask your lender before making extra payments if this is what you want to do.
How Loan Interest Works
Lenders agree to offer a loan to a borrower for a certain interest rate and term. Basically, the interest is the cost of borrowing money from the lender.
Interest rates are calculated based on a percentage of the unpaid principal balance.
The interest is typically expressed as the annual percentage rate (APR). This factors in the interest and any fees charged on the debt. The exception to this is credit cards which don’t include these fees.
Interest works and is applied to your debt depending on the type of credit and the lender. Simple interest and compound interest are the two types of interest lenders may charge on their loans.
Simple interest only applies to your principal balance. Your loan may accrue interest each day and is calculated using the rate and principal.
Compound interest includes the interest on the principal and interest that’s accrued since the last payment. That means that interest accrued every day is added to your daily amount. That increases your overall balance.
Interest is applied differently depending on the type of loan you have. Installment loans like mortgage, auto, student, and personal loans typically roll your interest in your monthly payment.
On the other hand, credit cards don’t charge you interest if you pay back the balance by the end of the due date.
What Increases your Total Loan Balance?
There are many reasons why your loan balance could go up. Below, we will discuss these reasons in detail.
Because of interest capitalization, your total loan value will go up. To understand how it increases your total loan, let’s look at an example.
Let’s say that you borrowed a student loan for your first year in college for $5,000. You are deferring payments until six months after you graduate. Your interest charges will accrue this debt for 54 months if you graduate in four years.
The interest rate on your student loan is 6% which equates to an interest amount of about $25 per month. That adds $1,350 of unpaid interest over the 54 months to your outstanding balance.
Your outstanding principal balance becomes $6,350.
To avoid this scenario, you could make loan payments towards the interest that accrues each month. Making a monthly payment on the unpaid interest will result in your total loan balance equaling the original $5,000.
You have a certain type of student loan or repayment plan
If student loans are the balance you’re seeing an increase on, chances are the type of student loan is the reason. Unsubsidized federal student loans, income-driven repayment plans, and extended plans can cause this situation.
Unsubsidized student loan
You’re responsible for the interest as soon as the loan is disbursed with an unsubsidized loan. That means that once you start paying it back, you must repay the original amount you borrowed and the interest that’s accrued since the loan was disbursed.
If you don’t start paying back the loan until after your six-month grace period from graduating, you’ll see that your balance has risen. That $30,000 that you borrowed will turn into $34,834.
Income driven repayment plans
This is a traditional loan repayment plan. With this type, your balance is amortized over a repayment schedule, called your loan term. What this means is that a portion of your monthly payment amount goes towards the interest that accrued since the last payment and the rest goes toward paying down the principal balance.
Your monthly loan payment is calculated differently on income driven repayment plans. Monthly payments are calculated as a percentage of your discretionary income.
Factors like your interest rate, total loan balance, and the monthly payment amount on an income driven repayment plan could result in not being covering your accrued interest each month.
So what it actually does on these income based repayment plans is increase your loan balance and total loan cost.
An Extended Payment Plan
If you select an extended payment plan, these loans last for 20 years or more. The total loan balance reduces over time, but much slower than other options.
You’ll owe significantly more interest when you repay a student loan over a longer period. The benefit for you is that regular payments are lower.
Making timely payments on these plans is even more important. One missed payment will lead to a higher loan balance since you’re paying less towards the monthly interest.
Making Monthly Payments of less than the Requested Amount
If your monthly payment doesn’t cover the requested amount, your loan balance could rise. This is due to capitalized interest.
Your payment must cover both the principal payment and the capitalized interest. Otherwise, the unpaid interest gets added to your total loan balance.
Deferring or Missing Payments
Forbearance is if you temporarily stop making payments. Interest capitalization occurs when this happens, which results in higher loan balances.
If you’re not paying the requested monthly payment, the unpaid interest accrues, increasing your total loan balance.
How to Lower your Loan Balance
The ideal scenario is that you avoid situations where your outstanding principal goes up. Below are a few tactics that could help you do this.
Make More Frequent Payments
Ask your lender if you can make more than one payment a month. If you have extra money available in your budget, making two payments a month can help reduce your loan balance faster.
Get a lower Interest Rate
Look for loan options that reduce your interest rates to make your loan more manageable. Look for a fixed interest rate loan if you’re currently on a variable rate. That will provide you with more consistency as well.
Some borrowers might have the option of using home equity loans to reduce the rate if they own a home.
Checking a ton of different options to find the right loan may seem overwhelming, but there’s no need to fear. Nowadays, you can see a variety of loan options all in one place with loan marketplace sites like AmOne and Credible. These sites work by gathering information on the type of loan you’re searching for and then matching you to possible options.
Borrow less Money
Limiting how much you borrow could help avoid this situation. Look for ways to reduce how much you need to borrow.
For example, if you’re in the market for a new car, then look at less expensive models. Or wait until you can save up more as a down payment.
Increase your Monthly Payment
The repayment schedule outlined by your lender isn’t necessarily one that you have to follow. You can make extra payments each month which will go help go toward the unpaid principal amount.
Talk to your lender first to make sure this is an option or to ensure that funds are allocated appropriately. On a mortgage loan, you can often pay more towards the balance by selecting that option on the lender’s website on your account.
Extra payments on auto loans often just go towards your next monthly payment. That’s why you should check with your lender before increasing your monthly payment.
Choose Loans with Lower Rate options
Some lenders will give you a discount for doing things like setting up auto-pay, if you have other accounts with them, etc. Ask your lender or servicer if they have any options like that available.
Start with Your Most Expensive Loan
When paying back your loans, start with the one that has the highest interest rate. Your interest payments on these loans are the highest, costing you the most money and increasing your total balance the most.
If you’ve used credit cards or personal loans as a borrowing tool, these are typically the best place to start.
Ask for a Temporary Rate Reduction
Your lender might be willing to give you a temporary rate reduction. With a rate reduction, your regular payments will help go towards paying off a larger portion of the principal.
Use your Savings if Necessary
It’s important to have money saved for emergencies and unexpected expenses. But if you can afford it, you might consider using part of your savings to pay back some loans. Loans with higher rates would particularly be good ones to use for this.