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Pay Down or Pay Ahead? It Can Be Confusing

Years ago I learned a lesson I won’t have to learn again. It was that poignant. It was during a time when mortgage interest rates took a nosedive and we benefited by refinancing our high-rate mortgage.

The transaction closed in late August with the first payment due in October. Rather than take a month off from making a mortgage payment we made an unscheduled payment in September to reduce the principal balance right off the bat. We sent a letter with the payment and wrote “Principal Prepayment” on the check.

A few weeks later we got a statement showing that the payment had been credited to the October payment, not to pay down the principal as instructed. The confused customer service rep was kind but hardly apologetic when she explained that someone must have assumed that we really wanted to “pay ahead” rather than “pay down.” It took a little persistence to convince her to the contrary.

Applying that payment to the principal balance was good for us because every penny of that unscheduled payment went to reduce the balance—no interest was due until October. That was profitable for us, but not for the lender.

By reducing the principal at the beginning of the loan, we would go on to save more than $4,000 in interest and cut three months off the term, which we did and oh what a happy day that was!

On the other hand, applying it to the October payment would have put almost the entire amount into the lender’s pocket in the form of interest.  Read more