What is Loan Principal?
As a borrower, understanding loans can sometimes feel like cracking a complex code. Among the various terms thrown around, "loan principal" is a key concept that’s essential for understanding the borrowing process.
“What is the principal of a loan, and why should I know about it?”
Put simply, loan principal is a core part of a loan product. It affects how interest is calculated, which impacts the total cost of the loan.
Whether you're considering a mortgage for your dream home, an auto loan for your next vehicle, or a personal loan for a project, understanding loan principal is crucial.
How the principal of a loan works
Loan principal is the money you borrowed from a lender, not including interest and fees. It’s the main amount that you need to repay over the loan term.
For example, when you borrow $10,000 at a fixed interest rate, the $10,000 is your loan principal. Each time your payment is applied to the $10,000, your principal amount lowers.
Interest is usually calculated as a percentage of the loan’s remaining principal. At first, a larger part of your payment goes toward interest because of the high principal amount. But as you pay down the principal, the interest portion of your payments gets smaller, which means more of your payment goes toward reducing the principal.
Understanding how loan principal works helps you manage your finances better. Paying down the principal faster can save you a lot on interest over the life of the loan. This knowledge can help you decide if making extra payments or refinancing to lower your overall costs is a good idea.
Types of loan principal
There are two types of loan principal balances to be aware of: initial and outstanding. We’ll explain the difference between the two in this section.
Initial principal
Initial principal of a loan refers to the amount of money borrowed at the beginning of a loan, excluding interest or fees. This is the loan you commit to repay over time, usually through fixed monthly installments.
For example, if you get a mortgage for $200,000, that $200,000 is your initial principal.
Outstanding principal
Outstanding principal is the remaining amount of the original loan that you still need to repay. It shows how much of the initial loan you still owe.
For instance, if you borrowed $20,000 and you’ve paid back $5,000 so far, your outstanding principal is $15,000.
When to expect loan principal
You can expect to pay loan principal when you borrow the following kinds of loans:
- Mortgages
- Home equity loans
- Car loans
- Personal loans
- Student loans
- Lines of Credit
- Credit cards
With each of these loan products, there’s an initial amount of money you borrowed or charged that you pay back to the lender over time.
Loan principal vs. interest
Another key distinction to make is the difference between the principal amount of a loan and the interest on a loan. We already explained that the principal is the original amount borrowed from a lender. Interest is the cost of borrowing that money, and it’s how lenders make money on loans.
If you get a $10,000 loan with a 5% annual interest rate, you pay 5% of the outstanding principal each year. Think of interest as additional money you pay for the convenience of borrowing from a lender.
How to find the principal of your loan
Your monthly loan statement provides everything you need to track your principal balance and understand what needs to be repaid. Here's a breakdown of the information you’ll find on a monthly loan statement:
- Principal balance. Your statement shows the current principal balance, letting you know how much of the original loan amount you have left to pay. It might be labeled as "Principal Balance," "Outstanding Principal," or "Loan Balance."
- Payment breakdown. Look for a section detailing your monthly payment. It shows how much goes toward interest and how much goes to the principal.
- Interest rate and charges. Note the interest rate and any charges listed on the statement. This shows the borrowing costs and how they impact the remaining principal.
- Payment history. Many statements include your payment history, allowing you to see how the loan’s principal has decreased with each payment.
- Extra payments. Additional principal payments are often listed separately. Extra payments can make a big difference in the principal balance and reduce your overall interest costs.
- Remaining term. The statement might show the remaining term of the loan, or the number of payments left.
How can a borrower pay back the principal of a loan?
Most loans are paid back in fixed monthly payments, which means your payment is the same amount each month. However, the way that your payment is used to pay off the loan changes over the life of the loan.
When you make a loan payment, part of it goes toward reducing the principal, and the other part covers interest. At first, more of your payment goes toward interest, but as the principal gets smaller, more of your payment goes toward paying down the principal. This is commonly known as loan amortization.
For example, let's say you borrow $20,000 with a fixed 5% annual interest rate to be repaid over 5 years (60 months). Your monthly payment is $377.42. At the start, a significant portion of this goes to interest, while the rest chips away at the principal.
Here’s how the payment division works initially and over time:
1. First payment:
- Interest: $20,000 (principal) x 5% (annual interest rate) ÷ 12 months = $83.33
- Principal: $377.42 (monthly payment) - $83.33 (interest) = $294.09
In the first month, $83.33 goes toward interest, and $294.09 is paid toward the principal.
2. Tenth payment:
- Let's assume the principal balance is now $17,500.
- Interest: $17,500 x 5% ÷ 12 = $72.92
- Principal: $377.42 - $72.92 = $304.50
By the tenth payment, the interest portion has decreased to $72.92, and $304.50 goes toward the principal.
You see that while your monthly payment remains the same each month ($377.42), the proportion allocated to interest decreases over time, and more goes toward the principal. This process continues until the loan is fully paid off.
Cracking the code on loan principal
Understanding the breakdown of interest and principal in your monthly payments helps you manage your loans effectively. Extra payments to pay down the principal faster reduce total interest over the loan's life, saving you money.
➢RELATED: Should I Pay Off My Loan Early?
If making additional payments isn’t an option, you might consider refinancing at a lower rate instead. Advance America offers personal loans that could be a solution to high-interest debt you currently have.
Visit us in-store or start your application online today.
