What Is a Loan Principal?

Understanding loan principal

No matter what kind of loan you get — whether you’re buying a car, a home or even furniture — the amount you borrow is called the loan principal. The principal is how lenders calculate your interest payments, and it can also be the foundation for any loan fees charged.

There are two types of loan principal: the initial principal and the principal balance.

• Initial principal: The initial principal is the amount you initially borrow for the loan. This is the base amount of your loan, which is used to calculate loan fees and interest.
• Principal balance: The principal balance is the amount that you still owe on your loan. As you make monthly payments, a portion of your payment goes toward the principal. Each payment lowers your outstanding principal amount until the loan is paid off.

Principal vs. interest

While the principal of a loan is how much you borrow, interest is a percentage that the lender charges for loaning you the money. Interest is usually described using an annual percentage rate (APR), which is the yearly cost of borrowing.

There are two types of loan interest charged:

• Simple interest: Simple interest is calculated based on a percentage of your principal balance only.
• Compound interest: Compound interest is calculated based on the principal balance and any outstanding interest.

When you first take out a loan, interest usually makes up a much higher percentage of your monthly payment. As you pay down the loan, the principal amount decreases, as does the amount of interest charged each month.

Example of loan principal and interest payments

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 loaning 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 process is 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 — 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.

Loan amortization breakdown by year

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,” said Joseph Camberato, CEO of National Business Capital, a fintech lending marketplace. “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,” he said.

» COMPARE: Principal vs. interest

How to manage your principal payments

The best way to manage your principal payments (and pay off your loan) is to make sure your payments are on time. But since your payment is split between interest and principal payments, there are a few additional things you can do to pay down your loan effectively and even become debt-free faster.

• Extra payments: Most loans allow you to make extra payments on your loan to pay it off faster. But you’ll want to make sure your extra payments are applied to the principal of the loan, not the interest.

  You can contact your lender to ensure any extra payments made during the month apply to your principal, which lowers the amount you owe and can save you on interest as well. Just watch out for loans with prepayment penalties.

• Paying more often: Some loans allow you to make multiple payments during the month. One popular hack is to pay your mortgage biweekly, which results in making one extra full payment per year (26 biweekly payments equal 13 total payments). This can cut a few years off your mortgage if you do it consistently.
• Refinancing: If your interest rate is high and you pay too much toward interest and not enough toward principal, refinancing can help. A lower rate and shorter repayment term on a loan means paying more toward principal each month, saving on interest and paying off the loan faster.

Make extra payments count

If you send extra money to your lender, ask that it goes straight to principal, not future interest, to pay off your loan faster.

» LEARN: Tips for paying off loans fast

Can your principal payment change?

When you’re making your monthly payments on an amortized loan, this means some of your payment goes toward your principal balance. Each month, the principal amount on your loan will get lower and lower.

But on the other hand, if you are making low payments or are in deferment, interest can accrue on your loan each month. In some cases, this interest is capitalized, meaning accrued interest is added to the principal balance of your loan. In this case, your loan principal will increase — a process known as negative amortization.

If you end up in a position where you can no longer afford your monthly payments, you may be able to work with your lender to modify the loan. As part of the modifications, lenders usually extend your repayment term, which lowers your monthly payment. But your lender may also forgive a portion of your principal balance as part of the loan modification.

The impact of inflation on loan principal

Inflation impacts loan principal by making it easier to pay off a fixed-rate loan over time. As prices rise, the dollars you use to repay your loan lose value, so your monthly payments feel smaller in the future even though the payment amount stays the same.

For example, if you have a $100,000 mortgage at a 6% interest rate on a 30-year term, your monthly payment doesn’t change. But after 30 years with 3% average inflation, those dollars don’t buy as much as when you first took out the loan. That means you pay back the loan with money that is worth less over time.