Discover What Increases Your Total Loan Balance and How to Avoid It

Posted on July 03, 2024 by Terryl Payne

When you apply for a loan, you receive an amount that you must repay to the lender. This is the loan principal. However, each loan comes with interest, which adds to the amount you owe and forms the total loan balance. Repaying the loan on time decreases this balance step by step. However, there may be situations when your balance will rise, even if you pay on time.

There are several reasons why it may happen, and some of them are non-obvious. Such factors are interest rate fluctuation, extended repayment terms, fines for late payments, and additional fees. Without understanding these factors, you may owe more than you planned. Let’s learn about the main factors that increase your loan balance and get practical tips to help you avoid unnecessary debt.

Everything You Need to Know About Your Loan Balance
Common Factors Behind Increasing Loan Balances
Strategies to Minimize Your Loan Balance Growth
Bottom Line

Everything You Need to Know About Your Loan Balance

Your loan balance is the total sum you owe to the lender. It consists of the borrowed amount and accrued interest and fees. Here’s a simple breakdown to help you better understand your loan balance:

Principal. This is the initial amount borrowed. For example, if you took out a consumer loan of $7,000, this is your loan principal. Interest. This is the cost of borrowing money expressed in an annual percentage rate (APR). Over time, the interest adds up, and the loan balance grows accordingly. Additional commissions. These may include loan origination fees, late payment fees, and other charges. Compound interest. It’s calculated on the original principal amount and the accumulated interest from previous periods. Such an interest is applied to certain loan types and can significantly increase your loan balance.

Learn More About Interest Rate Options

The interest rate is one of the key factors affecting the total amount of your loan. Understanding the different interest rate options will help you make the right loan choices and save money in the long run.

Simple Interest Rate

Simple interest is calculated on the loan’s principal amount, but accumulated interest is not considered. It is computed as a set percentage of the initial loan amount for a specific period.

For instance, if you borrow $10,000 at a simple rate of 5%, your interest will be $500 per year. The amount remains constant since it doesn’t consider your already accrued interest, simplifying calculations.

Compound Interest Rate

Compound interest accounts for the loan’s principal amount and previously accrued interest. This implies that whenever interest is accumulated, it is added to the overall sum and used as a basis for calculating interest at a later point. As interest “builds” on interest over time, this increases the overall loan balance.

Fixed Interest

A fixed-rate stays the same for the entire loan duration. This makes budgeting simple because your monthly payments will remain the same. Fixed rates are usually initially higher than adjustable ones, but the payment predictability makes them worthwhile. Such rates are typical for short-term loans.

Variable Percentage

A variable rate may be subject to change over time. If the market conditions change, your monthly payments could fluctuate. Although variable-rate loans have less predictability, they usually come with cheaper initial rates. An example is an adjustable-rate mortgage (ARM), where the interest rate is based on a particular benchmark, like the prime rate.

Base Rate

The bank offers a minimum interest rate for its most dependable customers. Rates on variable-rate loans and most credit cards are determined using this rate as a guide. The prime rate may change in response to market and economic changes. These changes impact the interest rates on various loan types and the overall amount you pay back on your loan.

Common Factors Behind Increasing Loan Balances

Before applying for a loan, you need to understand what factors can increase the total loan balance. Here the most common ones:

Interest Accumulation

The longer you take to repay the loan, the more interest accumulates. For example, if you borrow $1,000 at a 5% annual interest rate and plan to repay it over ten years instead of five, the total interest paid will be significantly higher.

$1,000 loan for ten years: total interest paid is $272.79. $1,000 loan for five years: total interest paid is $132.27.

So, by doubling the repayment term, you’ll pay almost twice as much in interest.

Late Fees

Repayment term violations can lead to higher interest payments and an increased loan balance. Suppose your monthly payment is $200, and the late fee is $25. You’ll owe $225 the next month if you miss a payment. Repeated late payments can significantly increase the amount you owe over time due to accumulating fees.

Capitalized Interest

Capitalization occurs when unpaid interest is added to the principal amount of your loan. This means you’ll pay interest on a larger principal balance. You owe $10,000 and accrue $500 in interest during deferment. Your new principal balance becomes $10,500, increasing the amount your future interest applies.

Loan Deferment or Forbearance

You may not be required to make payments during deferment or forbearance, but interest often continues to accrue. For example, during a 12-month deferment period, a $10,000 loan with a 6% interest rate might accrue $616,78. If this interest is capitalized, it’s added to your principal, increasing your loan balance to $10,616,78.

Insufficient Contribution Amount

Paying less than the set minimum could increase your loan debt. If your payments are too low, unpaid interest will be added to your monthly principal, increasing your total debt. In addition, penalties may apply for such small payments. Imagine you have a $10,000 loan with an annual interest rate of 10%. The monthly minimum payment is $1,000. If you pay less, say $800, the remaining sum is added to your debt and will be subject to interest. Therefore, paying at least the minimum amount is important to prevent your debt from growing.

Extended Repayment Plans

Extending your repayment period can lower monthly payments, but it also means more interest accrues over the life of the loan. If you extend a $30,000 loan from a 10-year to a 20-year repayment plan, your monthly payments decrease, but the total interest paid will be much higher. Here are calculations for an APR of 5%:

A $30,000 loan for ten years: The monthly payment would be approximately $318.20, and the total interest would be approximately $8,184. A $30,000 loan for 20 years: The monthly payment would decrease to approximately $198.53, but the total interest would increase to approximately $17,647.

Calculation Errors

The lender is responsible for calculating interest and principal, but sometimes mistakes happen. If you notice an error, contact your lender as soon as possible to correct the situation. Make it a rule to check your loan statements.

Variable Interest Rates

The cost of loans with variable interest rates can change based on market conditions. If the rate increases, your loan balance will grow, too. Let’s say you have a $50,000 loan with a variable interest rate that starts at 3% and later goes up to 5%. This growth will enhance your monthly payments from $482.80 to $530.33 and your total interest paid from $7,935.60 to $13,639.90.

Additional Borrowing

Taking out additional loans or increasing borrowing limits adds to your total loan balance. If you have a $5,000 credit card balance and make a new purchase for an extra $5,000, your total loan balance doubles. This increases your interest and makes it harder to pay off the debt.

Loan Servicing Fees

Some loans come with servicing fees, which can be added to your loan balance. For example, mortgage servicing fees might be added monthly or annually, increasing the total amount you owe over the life of the loan.

Strategies to Minimize Your Loan Balance Growth

There are several simple ways to reduce your loan debt:

Stop Missed Payments

Your balance will skyrocket if you don’t pay your loan on time. If you are experiencing financial difficulties, try to contact your lender as soon as possible to explain your situation. Some lenders may offer payment deferrals, allowing you to temporarily stop payments without charging additional interest. This will help control your loan balance and limit your debt.

Set Up Automatic Payments

If you are afraid of missing a loan due date, set yourself a calendar reminder, or better yet, set up automatic fund debiting. This feature will help you make payments on time, reducing the likelihood of late payments and increasing interest rates.

Use an Avalanche Method

This method lets you focus on paying off high-interest loans early and then move on to low-interest loans. This helps you save money and reduce your overall debt. By starting with the loan with the highest interest rate, you’ll pay less interest over time.

Increase Your Monthly Payments

Paying more than the minimum monthly is a great way to reduce your loan debt. This will help you lower your balance faster and save money on interest. Find some extra money in your budget for an extra monthly payment.

Finish Your Loan Payments Sooner

Paying off your loan early is a great way to reduce debt. Suppose you can make additional payments throughout the year. This will reduce your principal and interest, reducing your total debt. You will save on interest and reduce the repayment time by repaying the loan beforehand. Before doing so, check to see if your lender charges an early repayment fee.

Bottom Line

To manage your money sensibly and settle existing debt, you need to know how your loan balance can increase. Extended repayment schedules, capitalized interest, late fees, and variable interest rates can all contribute to an unanticipated increase in your loan total.

You can manage your loan debt by adopting techniques, including automating payments, the avalanche method — focusing mostly on high-interest loans — raising your monthly payments, and considering early repayments. You can save money by choosing simple, compound, fixed, or variable interest rate alternatives.

References:

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