What is a personal loan?
You can take out a personal loan for various purposes, then pay it back in monthly installments. Read more about how this kind of loan works.
Josh Richner
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.
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.
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.
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.
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Principal and interest make up your monthly payments on a loan or mortgage. Each monthly payment consists of:
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:
Beginning principal balance | Interest paid | Principal paid | Ending principal balance | |
---|---|---|---|---|
Year 1 | $12,000 | $999.23 | $1,989.97 | $10,010.04 |
Year 2 | $10,010.04 | $812.59 | $2,176.61 | $7,833.41 |
Year 3 | $7,833.41 | $608.38 | $2,380.82 | $5,452.59 |
Year 4 | $5,452.59 | $385.04 | $2,604.16 | $2,848.44 |
Year 5 | $2,848.44 | $140.73 | $2,848.47 | $0.00 |
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.
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.
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 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.
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.
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.
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.
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.
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