Reviewed by Michael Lefler People who take out loans typically use a loan calculator and don’t think much about what their total debt cost consists of. Meanwhile, every loan you take out can be split into two main parts: loan principal and loan interest. And both these components affect your monthly payment amount. But what is a loan principal? Let’s find out how it works with an example.
Table of Contents
- What Is the Principal of a Loan?
- Principal and Interest – What’s The Difference?
- Loan Principal vs. Loan Balance
- How Will You Repay Your Loan Principal?
- How to Determine a Principal Loan Amount?
- What Types of Loans Apply Loan Principal?
- Is It Possible to Repay a Loan Principal Balance Faster?
- Loan Principal And Taxes
- Final Thoughts
What Is the Principal of a Loan?
In terms of lending, the loan principal defines the initial sum that you borrowed from a lender. Also, the principal is the amount that you agreed to repay over the period specified in your loan contract. The principal amount goes down each time you make your monthly payments until your loan expires. This means that your principal balance will reach $0 in the end.
But you need to keep in mind that not the whole sum you pay goes toward the principal balance. There are also additional fees that are called interest. They are added to your principal balance and also need to be repaid. Thus, each monthly payment you make is divided into two parts and goes toward covering both principal and interest.
Representative example
Let’s take a closer look at how your loan principal payment is calculated. Let’s say you need $12,000 for one year to buy a car. You make a down payment that is $2,000, so your loan principal is $10,000. Suppose that a bank charges interest of 4% annually (the interest rate is fixed). By using a personal loan calculator, you can easily determine what will be the amount of your monthly payment ($851.50).
After you make your first payment, your principal balance will go down. Here’s how you can calculate how much of your monthly loan payment will go toward covering your interest balance:
Loan Principal x Interest Rate / Loan Term in Months = $10,000 x 4% / 12 = $33.3
As the example shows, in the first month, $33.3 from your $851.50 monthly payment will be used to cover accrued interest charges. The remaining $818.2 will reduce your initial principal. As your principal becomes lower next month, you will have to pay less in car loan interest. Nevertheless, your loan payment will be the same. This will last until your last payment, which turns your principal balance into $0.
Principal and Interest – What’s The Difference?
Let’s start with a definition.
A loan principal amount is the original sum that you decide to obtain. This amount is determined by your needs and income.
A loan interest is a value that is set by a lender. It’s the cost expressed as an annual percentage that you pay for the ability to take out money from a lender. Thus, your interest payments allow a loan provider to earn money.
When it comes to interest rates, your credit score plays a determining role. If you have a strong credit history and a high credit rating, your chance of getting a low annual percentage rate is higher. The lower your annual interest rate, the less will be an interest payment.
Summing up, the difference between these two lies in who sets the value. While loan principal is the sum that you decide to obtain in accordance with your needs, interest is the value that a lender sets for giving you the money.
Loan Principal vs. Loan Balance
At first sight, loan principal and loan balance are the same things. In fact, they can be the same in an ideal scenario when monthly payments are made on time, and only the interest is added. But for most loans, there will be a significant difference between these two.
The principal is the amount you owe that is used as a base for interest charges.
A loan balance includes your loan principal and all the additional charges you have to pay. These charges include fees, interest, penalties, and other inclusions. This way, your loan balance is commonly higher than your loan principal.
How Will You Repay Your Loan Principal?
When you start paying off a loan, most of your minimum monthly payment is more likely to go towards paying off interest. At the same time, even if your loan interest rate is fixed, as well as monthly payments, the part that goes toward each of the components will change over time. This is because the interest amount is calculated based on your principal balance. And, as we’ve already mentioned, your principal balance will become lower each month.
Also, some loans provide for the repayment of only the principal debt (without covering other initial costs). Usually, this is an additional payment that you make on top of the minimum one. However, if you make a principal-only payment, you may require to notify the lender that you intend to cover only your principal balance and not the interest.
How to Determine a Principal Loan Amount?
If you want to estimate your progress in covering your loan principal, you can check out your loan’s monthly statement. It can also be an initial disclosure statement (for a student loan), a bank’s closing disclosure (for a home loan), or a monthly mortgage statement. All these documents contain all the needed information about your loan payments and show the remaining principal balance. If you can’t find this information in your monthly statement for some reason, please, contact the lender.
What Types of Loans Apply Loan Principal?
You can expect to meet up with the principal balance when it comes to any loan with an installment structure. If your loan implies making several monthly payments over some time, it will come with both a principal balance and an interest balance. This can be applied to a car loan, home loan, long-term personal loan, business loan, student loan, credit card balance, and more.
Is It Possible to Repay a Loan Principal Balance Faster?
From now on, when you already know how loan principal works, we can move to a major question, “Can you repay the loan principal early?” The short answer is “yes,” but you need to specify whether the lender offers such flexibility. If it allows paying early, you can make extra payments to make your balance go down faster. But first, you need to notify the loan provider that you want to use this amount of money to cover your loan principal only.
Making additional payments can help you save money on interest, reduce the repayment period, and avoid stress.
Loan Principal And Taxes
For some types of loans, individual taxpayers can get a tax deduction. Mortgages and student loans are examples of debt with a tax-deductible loan principal. But keep in mind that your student loan or mortgage interest payments are not tax-deductible. This applies only to your principal mortgage payment. Also, if you have a business loan, you can count on a tax deduction too.
Final Thoughts
Before you take out any form of debt, you need to understand what it consists of. There are two main components of any loan repayment. The first is a loan principal, which is the money borrowed from a lender that you must repay within the agreed term. The second is loan interest, which refers to the cost you pay for using borrowed funds. These two are linked and can affect your total loan cost. If you know how to answer the “what is a loan principal?” question, it will help you better understand what kind of deal you get.
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