Consumers use loans to finance many items. Homes, cars and even a higher education are often paid for through the use of a loan product. Although this extension of credit can be convenient for the borrower, it often comes with finance charges. It's prudent to understand if making a larger loan payment can decrease these charges.
A finance charge is the cost the lender charges you for the extension of credit. A finance charge includes charges from accrued interest and other fees that are added to the principal of the loan. Interest rates and fees can vary widely. Lenders are required to disclose the terms and conditions of a loan to you, which includes the charges and fees that are applicable to your particular loan. One important disclosure is the interest rate.
A larger payment toward a loan balance will generally result in a decrease in finance charges. The interest rate impacts how much interest grows on your loan. The higher your interest rate, the faster added interest will accumulate on the debt. A smaller balance accrues less interest than a larger balance, so a reduction in the balance on your loan results in a reduction in the amount of accrued interest, which reduces the amount of your finance charges overall.
You can sometimes avoid finance charges. For credit cards, payment of the entire balance during the grace period each month prevents the accumulation of finance charges. This is especially helpful if you have a high-interest rate card. Also, a zero-percent interest rate card will not accrue interest, even if you carry a balance. However, if you take out a loan against the card, often called a cash advance, interest begins to accrue on it immediately. According to Bankrate.com, most cash advances do not have a grace period and carry a higher interest rate.
Some contracts for mortgage loans and car loans include a prepayment penalty fee. In this case, the lender imposes a fee if you pay off the loan balance early. Let's say you have a high-interest rate loan and want to pay it off early to save on finance charges. If your loan has a prepayment penalty and you do pay it off early, the lender may charge you up to three months worth of interest charges. Make sure you read the terms and conditions of your loan to see what applies in your case. Prepayment penalties do not apply if you pay extra on the loan, just if you pay it off early.