Loan Principal: What Is The Principal Of A Loan And How Does It Work?
Hanna Kielar4-minute read
PUBLISHED: March 17, 2023
When you take out a loan, you’re immediately hit with a lot of terminology you may not fully understand. Two of the most important terms are “principal” and “interest,” as they most directly relate to the amount of money you borrowed and how much you’ll pay back over time. Understanding the correlation between these two items can make a big difference in what you’ll owe over the loan repayment period.
Let’s examine what the principal of a loan is, how it differs from interest and how paying off your principal balance early could save you money.
What Is A Loan Principal?
The principal of a loan is the original amount of money you borrowed and agreed to repay in a specified time. Your loan’s interest is the sum you pay to borrow that amount. When you begin making your monthly payments on the loan, the majority of the money typically goes toward your interest, or late fees, if you owe any.
On What Loans Will You Have Principal?
You’ll find loan principal in most types of installment loans. Your owed principal should be clearly listed on your loan documents, along with your interest. Your loan repayment period ends once you’ve paid off your entire principal balance.
Loans you’ll see principal on include:
- Personal loans
- Auto loans
- Home loans
- Home equity loans
- Student loans
- Small-business loans
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What Is The Difference Between Principal And Interest?
As highlighted above, interest is the money you pay a lender in return for the lender offering you a loan. The amount of interest you owe is based on a percentage of your loan principal, called your interest rate. Your rate can be determined by the following factors:
- Your credit score
- Your debt-to-income ratio (DTI)
- Your borrowing history
- The type of loan you’re getting
- Where you live
- Your type of interest rate (fixed, adjustable, variable, etc.)
Your interest is often listed as your annual percentage rate (APR) and determines how much your monthly payment will be through a process called amortization, which breaks down your loan repayment into predetermined installments.
In short, your loan principal equals the amount you borrowed and agreed to repay, and your interest is what you owe your lender for loaning you that money.
How The Principal Of A Loan Works
Let’s say you take out a personal loan for $20,000. Here, your loan principal will be $20,000. If your interest rate is 6% at a fixed rate and your loan term is 60 months, you can calculate your monthly payment to be $387. You’ll pay a total of $23,199.36 by the end, which amounts to an additional $3,199.36 in interest, or the cost of the loan.
Typically, early on in your repayment period, most of your monthly payment is applied to the interest owed. As time goes on, however, more of your payment will go toward your principal and less to the interest, because as your principal amount becomes less, the remaining balance accumulates less interest.
Principal and interest payments can get a little more complex when discussing mortgages, since monthly payments on home loans involve additional costs related to home buying.
Paying Off The Principal On Your Loan
Since paying down your loan principal ultimately completes the repayment process, some borrowers may want to do so as quickly as possible.
If you can afford it, making extra payments toward your principal can shorten the amount of time you’ll spend paying back the loan and decrease how much you’ll ultimately pay in interest.
It’s important to communicate with your lender when making additional payments. If you don’t specify that you’re making a principal payment, they may apply your extra payment to the next monthly payment, meaning the amount will be split again between principal and interest.
You’ll also want to know whether you’ll incur a prepayment penalty where your lender charges a fee for paying your loan off early. Rocket Loans℠ doesn’t charge prepayment fees for approved personal loans.
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FAQs On Loan Principal
While the definition of a loan principal is relatively simple, it can bring up a lot of questions related to borrowing and paying back a loan. Let’s walk through some of the more popular questions below.
Can I pay off my principal before interest?
Yes, you can – if you’re making principal payments that go only toward the principal balance. Normally, your monthly payment is portioned between principal and interest, but you can make an extra payment and ask your lender to apply the funds solely to the principal. Some lenders may allow principal-only payments.
What happens when I pay the principal on a loan?
When you make principal payments on your loan, you lower the amount of interest you’ll owe over time. The amount you pay in interest each month is based in part on your principal balance, so a lower principal can equal a lower interest payment.
Is it better to pay interest or principal?
Since your interest is a percentage of your principal balance, the more you pay down your principal balance on a fixed-rate loan, the less you’ll owe in interest over time. Therefore, it could benefit you and your long-term finances to pay down your principal before the end of your loan term. Not everyone can afford to do this, however.
The principal balance on your loan will be what’s left of the original amount of money you borrowed. Interest will be money you owe the lender on top of your principal, and it can be directly affected by how much you pay down your principal. Some borrowers elect to pay down their principal as quickly as possible so they can save on interest. If you can afford the extra payments, paying off your principal could save you money in the long term.
Rocket Loans can offer unsecured, fixed-rate personal loans for $2,000 – $45,000. Start the application process today and see what interest rates you can qualify for.
Getting a personal loan has never been easier.
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