While most of us would prefer to avoid taking on debt, sometimes taking out a loan is an unavoidable part of life. For example, you might need to take out a loan to cover a major medical expense or pay for everyday day expenses while your paycheck catches up to inflated costs.
Everyone has their reasons for taking out a loan. If you have a personal loan, you aren’t alone. As of the third quarter of 2022, TransUnion reported 22 million Americans held this type of loan.
Regardless of your reasons for taking out a loan, the loan principal can spiral out of control quickly. Even if you are making payments, you might still see a growing loan balance.
5 Factors that can increase your total loan balance
Let’s explore the top factors that can increase your total loan balance.
Interest rates
When you take out a consumer loan, the lender attaches an interest rate to the loan. The loan agreement involves repaying the loan principal with interest. Depending on the loan structure, the interest rate tied to your loan can cause the loan balance to increase over time.
In many cases, interest can compound over time through a process called interest capitalization. Essentially this means that when your loan accrues interest, the interest payment is added to the loan balance. Moving forward, the higher loan balance, which includes accrued interest, is used to calculate interest. Over time, compounding interest can lead to a significantly larger loan balance.
Importantly, your annual percentage rate (APR) isn’t the same thing as your interest rate. The APR on your loan includes the interest rate and other fees tied to the loan origination.
Variable interest rates
A variable interest rate is an interest rate that changes over time. Typically, variable interest rates are tied to a benchmark or index rate that rises and falls based on market conditions. While variable interest rates can be attractive in a low-interest-rate environment, the threat of rising rates can leave you trapped with high-interest debt.
For example, most credit cards come with a variable interest rate. If you carry a balance, you are susceptible to a growing loan balance if interest rates rise quickly. Unless you can make larger payments to your outstanding balance, the loan balance will grow.
For example, a Federal Reserve report indicates that the average credit card interest rate rose from 14.51% in the fourth quarter of 2021 to 19.07% in November 2022. The steep rise might cause you to see a growing loan balance.
Only making the minimum payment
It’s tempting to stick with the minimum monthly payment. But if you only make a relatively small payment each month, you risk paying less than the interest accrued each month. The loan balance will rise if the interest charges outweigh your minimum monthly payment.
While the minimum payment might feel like a better fit for your budget right now, it might lead to a growing loan balance.
Making late payments
If you make a late loan payment, the first financial hit will likely be a late fee. But another issue is that your loan balance will continue to accrue interest, leading to a larger balance.
Regularly making late payments could have a significant impact on your loan balance.
Missing a payment
If you miss a payment altogether, you might encounter many negative consequences. One major issue is potential loan default concerns.
But missing a payment can give your loan balance a chance to grow even more. Without making the payment, your loan balance will initially remain the same. However, it gives your loan a chance to accrue interest on a larger loan amount. With that, you can quickly see a higher loan balance after missing a payment.
Making every effort to keep up with your payments can help you avoid a rising loan balance.
Tips to keep your loan balance from increasing
When you have a loan balance, it’s uncomfortable to see it rise over time. If nothing changes, you could be stuck with this debt for a long time. For more borrowers, the ideal situation is to see their loan balance shrink over time. But at the very least, you’ll want to prevent your loan balance from growing.
Here are some ways to avoid a growing loan balance.
Make on-time payments
If possible, make on-time payments for the full amount due. While it’s often easy to get behind on your payments, that might leave you with a growing loan balance.
The long-term cost of late payments can add up quickly. If you struggle to remember payment due dates, consider setting up an automatic payment option. Many lenders allow you to set up automatic payments, and some even give you a discount when you choose autopay.
Making payments on time can also come with other benefits, like an increased credit score.
Pay as much as you can
The minimum monthly payment won’t get you out of debt quickly. It can take a significant amount of time to see any progress toward a lower loan balance. Instead of sticking with the minimum monthly payment, consider making a larger payment each month.
Determine what size payment you can afford by closely examining your budget. If you want to get out of debt faster and avoid growing loan balances, consider cutting back on spending or increasing your income to accommodate larger monthly payments.
Consider making a lump sum payment
While paying off debt, you often have the option to make a lump sum payment to lower your loan balance. Depending on your situation, you might pull together a lump sum payment from a windfall or your savings.
If you are looking to use your savings to lower your loan balance, carefully assess your financial situation. It’s often the right move to keep some emergency savings on hand. Beyond that, your savings might be put to good use paying off high interest debt.
Growing loan balances are a drain on your financial future
As a borrower, it’s often easy to access more funding than you can reasonably repay in a short timeline. Before signing up for an extensive amount of consumer debt, take a close look at your budget. Make sure you can afford to make regular payments that make a dent in the loan balance each month.
For example, if taking out a personal loan, shop around to find the best interest rates for your situation. Understanding what increases your total loan balance can help you map out a loan repayment strategy that avoids a growing loan balance.
While paying off debt, do your best to avoid late payments. When possible, make it a point to throw extra funds toward your loan balance. If you need to consolidate debt, a personal loan through Prosper might help.