What is a Loan Principal?
When taking out a loan, the principal amount refers to the initial sum you borrow and need to pay back over time. This sum is used as a foundation for calculating your interest and the total loan cost. As you steadily pay down the loan, you decrease the principal amount you owe and can save money on interest by paying off your loan early.
We’re here to help you better understand what the principal on a loan is and how it works so you can make smart money moves.
- The loan principal is the amount you initially borrow from a lender.
- The principal amount is used to calculate your total interest paid for borrowing money.
- As you pay the principal over time, your interest monthly payments steadily decrease.
- Amortization is a process of determining how your loan monthly payments are spread out over time.
- At first, most of your loan payment typically goes toward paying off interest. Over time, the sum allocated to cover principal rather than interest increases.
- Some types of loans let you pay down the principal early without penalty. It can reduce the total interest you pay in the long run.
What is the Principal of a Loan?
The loan principal is the sum you borrow before a lender stacks interest and fees on top. It’s the pure loan amount you get on hand when you take out a credit card, personal loan, mortgage, car loan, student loan, and other forms of debt.
Here’s how it works. Suppose you want to buy a house that costs $250,000. A lender requires you to make a down payment of 20%, or $50,000. As a result, the loan principal on your mortgage is $200,000. The repayment term is 30 years, and your loan provider then charges a fixed annual interest rate of 3% on this sum.
The monthly payment is $843, but it doesn’t include property taxes or insurance. Of that $843 payment, $500 covers your interest charge, and the remaining $343 goes toward your loan’s principal. After you make your first monthly payment, your loan principal balance decreases from $200,000 to $199,657. Each subsequent month, interest is calculated based on the remaining principal, with the remainder of your payment reducing the principal further. This process repeats for 30 years until the loan balance is paid off completely.
Is Initial Principal the Same as Loan Balance?
The initial principal definition shows that it differs from the loan balance. However, these two are related. When you first take out a loan, the principal is the total amount you borrowed. But then you start making monthly payments, which reduces that principal amount over time. The loan balance is whatever you currently owe at any point. It decreases as you make monthly payments but can increase if interest or fees get tacked onto the amount you owe. So, the principal is the starting figure, and the balance is the fluctuating current figure that began on the principal but has moved up or down while you pay off your loan.
Principal on Investments
You might run into the word principal when talking about investing. What someone puts down as their cash at first is the principal, separate from any money they earn. With bonds, you get interest based on how much you initially put in. For stocks, your stake goes up over time beyond your first purchase from capital gains and price rises.
Loan Principals and Taxes
In fact, paying down the principal doesn’t affect your taxes. However, your interest payments can reduce your taxes under certain conditions.
If you make a monthly mortgage payment, some of the interest you pay might be tax deductible, lowering your taxable income. However, there are certain limits on the deductible amount. You should check with an accountant to see if you qualify.
The interest rates for student loans, home equity loans, and some business loans may be tax-deductible, too. But there may be specific rules and spending restrictions applied.
Difference Between Loan Principal & Interest
To help you better understand the difference between principal and interest, we’ve made a comparison table that outlines the main aspects:
| Aspect | Principal | Interest |
|---|---|---|
| Definition | The original amount borrowed or outstanding debt | The cost of borrowing money |
| Purpose | Represents the actual amount of the loan | Represents the cost of borrowing the principal |
| Portion of payment that goes toward it | Typically, increases over the loan term | Typically, decreases over the loan term |
| Payment | Principal payments reduce the loan balance | Interest loan payments compensate the lender |
| Calculation | Not subject to change unless monthly payments are made | Calculated as a percentage of the outstanding balance |
| Impact on total payment | Principal payments reduce the total loan amount | Interest payments contribute to the total cost of the loan |
Principal and interest are different concepts that matter in your loan costs. To calculate a simple interest on a loan, you can use the following formula:
Interest = Principal x Interest Rate x Time (in years)
Let’s say you take out a $10,000 personal loan for some home improvements, and the lender charges you 5% interest per year. You plan to pay back the loan after one year.
Interest = $10,000 x 0. 05 (5%) x 1 year
Which equals $500
When the loan is due at the end of that year, you owe $10,500.
How Does Repaying Your Loan Principal Work?
Paying back a loan involves more than returning the money you initially took out. You should pay back the principal plus interest and any extra fees associated with your debt. Here’s how it works:
Loan Payments Division
When you make a monthly payment on your loan, part of it goes toward knocking down the principal, and part of it goes toward covering the interest. Early on, more of your monthly payment covers the interest, but over time, the amount that goes toward your principal increases.
Amortization
As you keep making payments month after month, the principal balance starts shifting. The lower your principal, the less interest you have to pay. As time passes, the major part of the payment goes to the loan repayment. This process of steadily paying down debt through regular monthly payments over time is called amortization.
Principal-Only Payments
Some lenders let you make extra principal-only payments applied directly to pay down the principal balance instead of interest. Making those extra payments can help you repay the loan faster and save money. When the principal drops, you pay less in interest, reducing your loan cost.
Identifying the Loan Principal
The loan statement clearly shows your monthly payment breakdown between the principal and interest. It will typically display the total payment amount, interest, and principal part you’re covering. If you’ve made an extra principal-only payment, your statement shows that, too. This is how you can see how much principal you’ve paid off so far.
Your Credit Score & Loan Principal
Your credit score and the loan principal amount you take out are tied together, influencing each other in specific ways. Here’s a quick look at how on-time payments toward the loan principal and the actual size of the loan principal can impact your credit score:
On-time payments boost your score
Your payment history is a big part of calculating your score, so on-time payments help make you look more creditworthy overall. Paying your loan principal on schedule shows lenders you can handle debt responsibly. This results in improving your credit score.
Decreased credit usage ratio
Your credit utilization ratio (how much credit you use versus the total credit available) also greatly determines your score. When you get a credit card, the principal is the sum given to you. As you start using this money, you increase your credit utilization, which can negatively impact your credit score if you go beyond a certain percentage of your overall limit (use more than 30% of available credit).
Bottom Line
Understanding what loan principal means is crucial if you want to be financially savvy. It’s the core amount you borrow, without including interest payments or fees. It directly impacts your monthly payments and the total cost of the loan over time.
When you gradually make your monthly payments, you reduce your principal loan balance, which is also called amortization. At first, most of your payment goes toward covering your interest, but over time, the amount that covers your principal increases. By paying off the principal amount early, you can repay your debt faster and save money on interest.
Explore our website if you want to get smarter about budgeting, building credit strategically, and controlling your money. Access our resources about responsible borrowing tailored to help you gain financial literacy, feel empowered, and improve your credit score.
