What is a loan principal?

The amount you borrow isn’t necessarily the total you’ll pay back

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A loan seems like a fairly simple concept: you borrow money and pay it back with interest. However, to truly understand the cost of borrowing, you need to know the differences in loan terminology, including between principal and interest.

The principal on a loan is the amount of money you borrow from the lender, while interest is essentially the cost of borrowing these funds. Better understanding how these two relate — and how they’re distinct from one another — could help you save some money in the long run.


Key insights

  • The specific loan amount is the principal.
  • The loan principal decreases as you make payments over time, which means you owe less of a loan balance.
  • You can typically pay off your loan balance early without penalty, which can save you money in interest charges over the life of your loan.

Understanding the loan principal

Loan principal is the total amount you borrow from a lender. When you ask for a specific loan amount, you are asking for an amount of principal.

The principal on a loan may end up being higher than the original amount you request if your lender lets you roll fees into the principal. For example, on a mortgage, a lender might charge an origination fee of 1% of the principal. If you are borrowing $300,000, you may have the option to roll the $3,000 fee into the principal amount, increasing it to $303,000. This applies to any type of loan, including auto and personal loans, too.

The principal amount also varies based on your down payment (if your loan requires one). Making a higher down payment when buying a car or house lowers your principal. It also lowers the amount of interest you’ll owe over the life on the loan, which reduces the overall borrowing cost.

Principal in investments

In investing, the principal refers to the initial amount of money invested or borrowed. It’s the original sum of money before factoring in any interest, gains or losses. The principal amount remains constant unless you make additional contributions or withdrawals to the investment. The returns or interest earned on the principal is what determines the growth of the investment over time.

Loan principal vs. principal balance

The term “principal” is used in two different ways when talking about loans, referring to the two ends of a loan: how much you’ve borrowed and how much you still owe.

  • The starting loan principal is the original amount borrowed at the beginning of the loan term. As you make payments on the loan, the payments decrease the principal balance over time.
  • The principal balance represents the remaining amount owed of the loan. The principal balance reduces as you gradually pay off the borrowed amount. The lender should provide you with access to this information or include it in your monthly statements so you can track each month if needed.

» COMPARE: Best personal loan companies

How interest works with your principal

Principal and interest make up your monthly payments on a loan or mortgage. Each monthly payment consists of:

  • An interest portion, which pays the lender for lending you the money
  • The principal portion, which goes toward reducing the original loan amount

As you continue making payments over time, the interest portion decreases while the principal portion of the loan increases. You’re gradually paying down the debt until it’s fully repaid. This is a process known as amortization.

As an example of how loan payoff works, say you take out a $12,000 personal loan with a 9% fixed interest rate over five years. According to your amortization schedule, your monthly payment is $249.10 each month. In your first payment, $159.10 goes toward principal and $90 toward interest.

Your 30th payment — when you are about halfway through your loan term — consists of $197.60 in principal and $51.50 in interest. Your last payment will only have $1.85 in interest, with the rest going toward principal.

Here’s how the payments break down on a yearly basis:

At the end of the fifth year, you’ll have paid off the $12,000 principal and paid $2,946.02 in interest.

“It's worth noting that some people assume that their capital cost is exclusively determined by their interest rate percentage. Yet, the loan repayment term also plays a pivotal role. For instance, a $100,000 loan at 9% interest over four years will result in a higher cost for the borrower, compared to a $100,000 loan at 13% interest over one year," explained Joseph Camberato, CEO of National Business Capital, a fintech lending marketplace.

» MORE: Principal vs. interest: What’s the difference?

Paying off your loan principal

While your monthly payments will keep you on track for paying off your loan within the loan term, it is possible to pay extra towards the loan principal, thereby reducing the total amount owed. You’re paying less interest over time, which means the loan costs you less.

Principal-only payments

By making principal-only payments, you can directly reduce the outstanding loan balance without affecting interest payments. Most lenders only allow principal-only payments when they occur in addition to regular payments; however, as long as you are also making your regular payments, you can make additional principal-only payments at any point during the loan term.

Interest-only payments

Interest-only payments cover only the interest charges and don't reduce the principal amount. The lender may only offer interest-only payments for a limited time, usually in the early stages of certain loan types, before regular payments kick in.

If you’re planning on adding principal-only payments or if you have the interest-only payment option with your loan, check with your lender for the terms and conditions regarding these types of payments.

» MORE: Can you pay off personal loans early?

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FAQ

When do you start paying more principal than interest?

It depends on the amortization schedule of your loan. For example, on a 30-year, $400,000 fixed-rate mortgage with a 6% interest rate, the “tipping point” occurs in the 19th year of payments. If the rate on the same loan is 4.5% over 30 years, this occurs earlier, in year 15. As you shrink the loan term or lower the interest rate, the tipping point occurs sooner in the loan term.

Are there penalties for paying off the principal early?

This depends on the lender, so be sure to ask as you’re shopping around and comparing lenders. Some lenders charge prepayment penalties for early loan payoff, but this is typically found with loans specifically for those with lower credit scores.

Will paying down my principal reduce my monthly payments?

In general, no, especially with mortgages and auto loans. Making extra payments or paying more than your minimum payment helps you pay off the loan faster and reduces the amount of interest you pay over the loan term. However, it doesn’t reduce the monthly payment amount. Be sure to specify to your lender that the extra payment should go toward the principal.

Bottom line

When you’re paying back a loan through amortization — whether it’s a mortgage, auto loan or personal loan — it’s common for most of your early payments to only go towards interest. As you approach the end of the loan term however, more of the monthly payment goes toward paying down the loan principal.


Article sources
ConsumerAffairs writers primarily rely on government data, industry experts and original research from other reputable publications to inform their work. Specific sources for this article include:
  1. Investor.gov, “ Principal .” Accessed Aug. 3, 2023.
  2. Consumer Financial Protection Bureau, “ How does paying down a mortgage work? ” Accessed Aug. 3, 2023.
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