What is a loan principal?
Monthly payments are divided into interest and principal
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 are connected — and also different — could help you save some money in the long run.
Loan principal definition
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.
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 of the loan, which reduces the overall borrowing cost.
Principal vs. interest
While principal is the initial amount you borrow from a lender, interest is the cost of borrowing, reflected as a percentage of the total loan amount per year. When you make a loan payment, part of each payment is going toward principal, and part is going toward interest. As your principal balance decreases, so does the amount of interest you pay. This process is known as amortization.
Compare lenders not just on interest rates but also annual percentage rates (APR),
which include interest and fees.
No matter the type of loan, you’ll want to compare offers from multiple lenders to find a good interest rate. A borrower from Nevada on our site mentioned relief upon getting “the best interest rate” from a lender: “It is refreshing to see the principal on the loan actually making a difference in our balance — unlike our previous lender, where the principal only dropped $16,000 in seven years.”
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 the amortization schedule, your monthly payment will be $249.10 each month. In your first payment, $159.10 will go toward principal and $90 toward interest.
Your 30th payment — when you are about halfway through your loan term — will consist 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 would 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.
FAQ
- How do you calculate a monthly payment on a loan?
The basic formula for a monthly payment is the amount of principal plus the amount of interest. On a mortgage, there are often other components to your payment, such as property taxes and insurance. Lenders often have calculators on their websites that help you figure out monthly payments; alternatively, you can use a free online loan calculator to plug in your principal, interest rate and loan term to compute the monthly payment.
- When do you start paying more principal than interest?
It depends on your amortization schedule. On a 30-year, $400,000 fixed-rate mortgage with a 6% interest rate, this “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.
- Do large principal payments reduce monthly payments?
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, in general, 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
If you’re looking into taking out a loan of any kind, you can expect to encounter lots of talk about principal and interest. 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 be going toward interest. Toward the end of the loan term, more of the payment goes toward paying down the principal.
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