Principal vs. Interest: What's the Difference?

What is principal?

Your loan principal is the initial amount of money you’ve borrowed from a lender. It’s the original sum that must be repaid (excluding any interest and other fees) over the course of the loan term.

You may sometimes hear a reference to principal balance, too. The principal balance is the original amount borrowed minus any payments you’ve made toward the principal. Or, put another way, it’s the remaining amount you still owe.

What is interest?

Interest is simply the cost of borrowing money.

Lenders charge interest as a way of profiting from lending money. This means you have to pay back what you originally borrowed plus some extra. However, the amount of interest lenders charge differs.

The amount of interest you pay is generally calculated based on an interest rate. It’s often expressed as a percentage of the amount you borrowed (the principal).

Fixed vs. adjustable interest rate

A fixed interest rate remains constant throughout the entire loan term, meaning you pay the same interest rate on the principal amount for the duration of the loan. You may prefer this because it provides stability and predictability (since monthly payments remain unchanged), which makes budgeting easier.

In contrast, an adjustable interest rate, also known as a variable or floating rate, fluctuates based on market conditions. It may start with a lower rate initially, but it can rise or fall over time, leading to varying monthly payments. While it makes for uncertain (and potentially riskier) payment amounts, there is potential for the payment amount to decrease if interest rates drop.

“A fixed-rate loan locks your rate and payment throughout the life of the loan. Knowing what your payment is each month is a huge advantage from a budgeting perspective. Variable-rate loans come with uncertainty — payments can go up or down,” said Ryan Conte, chief revenue officer at Propell Credit Union.

“If the rate/payment does increase, refinancing is always an option but could end up being a higher rate than what the borrower would have received initially applying for a fixed rate.”

How principal and interest work in loans

Diving deeper into how these two components are calculated, as well as the different types of interest, can help you figure your potential loan payments so you know what to prepare for.

How principal and interest are calculated

If you pay your loan back in installments, which is typically the case, calculating your payments can get somewhat complicated because of how interest and amortization work.

Generally speaking, your lender applies the payment you make each month (or biweekly) to both principal and interest. Assuming your loan has a fixed interest rate, your recurring payments should stay the same as you pay back your loan.

However, the amount going to principal and the amount going to interest can differ throughout the life of the loan. Amortization helps keep your monthly bill consistent by allocating how much of each payment goes toward interest and how much goes toward principal.

With amortization, the initial payments you make are interest-heavy. This means your early payments mostly go toward interest rather than principal. As time goes on, more of each payment gets allocated to the principal debt.

For example, spread out over five years, a $50,000 loan would cost you $967 per month with a 6% interest rate. This means you’d pay back $7,998.40 in total interest, plus the $50,000 principal.

Your lender should provide you with an amortization schedule outlining how much your payments are throughout the loan’s term, how much of each payment goes toward interest and how much goes toward the principal.

Simple interest vs. compound interest

Interest is either calculated as simple or compound. Simple interest is interest only on the principal amount of a loan over a specific period. It remains the same for each period and doesn’t include any previously earned interest.

Compound interest takes into account both the initial principal and the accumulated interest from previous periods. As interest continues adding to the principal, the interest earned in each subsequent period grows. It essentially becomes “interest on interest.”

» MORE: How interest rates affect buying power

APR vs. interest rate: Understanding the true cost of borrowing

The interest rate on your loan is not technically the same as its annual percentage rate (APR). Though these terms are sometimes used interchangeably, they are two different things, and both are important to understand.

• The interest rate on your loan is the cost you pay to borrow the funds from the lender.
• Your loan’s APR reflects its interest rate plus other expenses, such as mortgage points, fees and any other charges associated with borrowing the money.

The APR is a broader measure of what the loan costs you to pay back, so it’s typically higher than the pure interest rate. If you're comparing loan offers from different lenders, make sure you’re evaluating APRs and interest rates separately. Don’t compare the interest rate from one lender with the APR of another, for example.

» MORE: Mortgage APR vs. interest rate

FAQ

Bottom line

When the time comes to borrow money, the more you know about the factors involved, the better. Whether you’re trying to get a personal loan or buy a house, knowing what principal and interest are and how they interact is critical to understanding how your loan works.

With the right information, you can compare loan terms, make good financial decisions and save money in the long run.