Principal vs. interest

If you’re looking to borrow money, it’s important to know how much you’re borrowing (the principal), the cost of borrowing it (interest) and how these amounts are related. Let’s break down what these two parts of a loan are and how they can impact you.

Key insights

• Your loan’s principal is the amount that you borrow.
• Interest is what you pay to borrow that money, usually expressed as a percentage of the principal.
• Your loan’s principal, interest rate, repayment term and fees will decide how much you ultimately have to pay back.

Principal and interest defined

According to the Consumer Financial Protection Bureau (CFPB), “Principal is the money that you originally agreed to pay back. Interest is the cost of borrowing the principal.”

There is more to each of these terms, though, and understanding them may save you money on your next loan. Here is a closer breakdown of what principal and interest really mean.

Principal

The principal on your loan is the amount you get from your lender.

Let’s say you borrow $50,000 to renovate your home. That $50,000 is the principal on the loan. When you sign a loan contract, you agree to repay all of that $50,000. However, that's not all you typically have to pay back.

Interest

Lenders charge interest as a way to profit from lending money. That means you have to pay back what you originally borrowed plus some extra. However, the amount of interest lenders charge differs from one lender to the next, as well as between different types of loans.

The amount of interest you’ll pay is generally calculated based on an interest rate. This rate is given as a percentage of the amount you borrowed (the principal).

How are principal and interest calculated?

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

Generally speaking, your lender will apply 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.

Free amortization calculators are available online.

However, the amount that goes to principal and the amount that goes 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 will be interest-heavy. That means your early payments will likely go toward interest rather than principal. As time goes on, more of each payment will be allocated to your principal debt.

Spread out over five years, our $50,000 sample loan would cost you $943.56 per month. That means you’d pay back $6,613.79 in total interest plus the $50,000 principal.

Your lender should provide you with an amortization schedule that outlines how much your payments will be throughout the loan’s term as well as how much of each payment goes toward interest and how much goes toward the principal.

Is it better to pay off principal or interest first?

As a general rule, it’s better to pay off your principal first. Although your amortization schedule will outline a plan for paying off your loan, you may be able to pay it off faster and avoid some interest by putting extra money toward your principal. The faster you pay off your loan principal, the less you’ll pay in interest.

If you hope to do that, though, let your loan servicer know that the extra money should be applied to the principal, not interest. Most loan servicers allow you to make this clear when you're completing your payment information. It might be smart to get confirmation in writing, though. A reviewer from Washington claimed their lender put the extra money toward interest despite verbal instructions to put it toward the principal.

Also, check if your lender will charge you prepayment penalties before you pay off your loan early.

Interest rate vs. APR

It’s also worth mentioning that 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, like mortgage points, fees and any other charges associated with borrowing the money.

The APR is a broader measure of what it will cost you to pay back the loan, 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.

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.