Loan principal: What is the principal of a loan and how does it work?

Borrowers commonly ask: What is the principal of a loan? In short, it describes the amount of money that you’ve elected to borrow from a lender. Basically, the larger the sum that you choose to borrow as part of a loan is, the higher that your loan principal is in turn – and the more that your monthly payment will be.

Put simply, when you take out a loan, paperwork will reference two terms prominently: principal and interest. Each specifically describes the amount that you’re looking to borrow as well as the costs that are associated with the loan and your decision to repay it over time, respectively. Understanding the correlation between the two numbers and how they relate to your monthly charges can help you get a better sense of what you’ll owe on a regular basis and over the course of the overall loan period.

Let’s take a closer look at the principal of a loan and how it differs from interest charges. We’ll also review how making a point to pay down (or pay off) your principal balance early could save you hundreds or even thousands of dollars and put more money back in your pocket on a recurring basis.

What is a loan principal?

Put simply, the principal of a loan describes the original amount of money that you’re seeking to borrow and repay over a specified period of time.

But of course lenders won’t simply hand you that money for free. It’s important to note that over the life of the loan, interest charges will also accrue on any sums borrowed (effectively costs paid to the lender for their services), which increase the total amount that you will have to repay.

In other words, any monthly charges that you incur as a part of a loan go toward paying a lender both for the principal (amount borrowed) and interest charges (service fees) associated with servicing the loan. Also, the amount that you’ll pay in total for the privilege of having access to the loan in the end will exceed the original amount of money that you’ve chosen to borrow.

When you first start making monthly payments on the loan, it also helps to be aware that the majority of payments made typically go toward covering your interest, or any late fees, if applicable.

Also, take note: While some lenders may charge prepayment fees for paying loans off early, you generally have the option of making a larger monthly payment than the lender is asking and applying the extra funds toward paying down your principal if you’d like as well. Doing so can help lower your monthly charges and expenses due to interest, which is charged against the loan principal.

Keep in mind that if you’re thinking about borrowing, the good news is as follows: Rocket Loans℠ does not charge any prepayment fees for approval on personal loans.

On what loans will you have principal?

For those asking: “What is the principal of a loan?”, it helps to be aware that you’ll find one associated with most types of installment loans. The amount that you’ve chosen to borrow in the form of this principal should be clearly listed on your loan documents, alongside the interest rate that you’ve agreed to be charged by the lender.

Of course, your principal balance will also decline over time as funds paid to your lender are applied to it – and your loan repayment period will end once you have paid off your entire principal balance. Hence the reason that lenders may apply a prepayment penalty if you elect to pay down loan principal early: They’ll earn less money in interest fees than initially anticipated.

Types of loans that you’ll see information about principal on include:

• Personal loans
• Auto loans
• Home loans
• Home equity loans
• Student loans
• Small-business loans

The impact of inflation on loan principal

However, inflation can also negatively impact the overall demand for loans (making individuals more inclined to borrow before prices jump). This heightened demand may prompt lenders to issue higher interest rates or apply more stringent lending criteria. As a result, lenders may choose to weave certain clauses into lending agreements that adjust the interest rate on a loan in the wake of potential future changes in inflation.

Inflation causes money to be worth less. In other words, should inflation kick in, several years after you’ve initially taken out a loan, you could be paying your lender back under terms more favorable to you as a borrower, especially if your salary has increased commensurately.

What is the difference between principal and interest?

As noted earlier, interest describes the money that you’ll be obligated to pay to a lender in return for them offering and choosing to service your loan. The total amount of interest that you’ll owe on monies borrowed is based on a percentage of your loan principal, known as your interest rate. Your individual interest rate, which can vary based on your individual lender, credit history, etc. may be determined by factors such as:

• Your credit score
• Your debt-to-income ratio
• Your borrowing history
• The type of loan that you’re getting
• Where you live
• Your type of interest rate (fixed, adjustable, variable, etc.)

Interest is commonly displayed in the form of an annual percentage rate. Your APR effectively determines how much your monthly payment will be in total. Charges are computed through a process called amortization, which basically breaks down your loan repayment into predetermined installments.

In other words, your loan principal is the amount of money that you’ve chosen to borrow and repay. The amount of money that you owe in interest describes the charges that you’ve agreed to pay to your lender in exchange for them being willing to loan you the money.

How the principal of a loan works

By way of illustration, let’s say you choose to take out a personal loan for $10,000. Your loan principal is therefore $10,000.

If your interest rate is 8% at a fixed rate and the total term of your loan is 60 months, your monthly payment computes out to be $203. Over the 5-year course of the loan’s lifetime, you’d pay a total of $12,164.85, or an additional $2,164.85 in interest paid to your lender.

The overwhelming majority of your monthly payment (especially at the beginning months of the loan term) is applied to paying the interest owed on the loan. As time goes on though, it’s typical to see that more of the payments that you make are allocated toward paying off the loan principal. What’s more, as your principal amount decreases, the remaining balance on your loan accumulates less in interest charges.

In short, interest charges go toward paying off your lender and principal payments go toward paying down your actual borrowed balance. The faster that you can decrease your loan principal, the quicker you can lower your monthly charges and overall loan expenses.

Note that principal and interest payments are somewhat more complex when discussing mortgages, since monthly payments on home loans involve additional costs related to home buying.

How loan amortization affects the loan principal

An amortized loan is effectively paid back by the borrower over a preset period in the form of fixed monthly installments. Under an amortization schedule, a portion of each payment made by the borrower goes toward covering the interest (cost of servicing the loan) and the rest goes toward covering the principal (amount borrowed).

As alluded earlier, a higher percentage of monies paid in initial monthly payment installments goes toward paying off interest. Later, monthly payment installments put more money toward paying down the loan principal. In effect, as the balance of your loan decreases, the interest portion of each payment shrinks while the portion devoted to paying off principal increases, with charges ending upon full repayment of the loan.

Bear in mind, however, that amortization is calculated differently on different types of loans, such as home loans, car loans, and personal loans. You can use mortgage amortization calculators and loan amortization calculators to quickly compute your potential costs here.

Paying off the principal on your loan

Because paying down the balance on your loan principal ultimately completes the repayment process, and gets you out of debt, some borrowers actively seek to do so as soon as possible.

In practical terms, making extra payments toward your loan principal serves to shorten the amount of time that you spend paying back the loan. It also decreases the amount that you’ll pay both monthly and in total due to interest charges.

At the same time, if you’re considering making extra payments, it’s important to communicate with your lender first. For starters, if you don’t specify that you’re making a principal payment, they may apply the extra payment to your next monthly charges, effectively splitting the amount again between principal and interest expenses. On top of it, you’ll also want to be aware of if you’ve incur a potential prepayment penalty, in which case a lender would charge you a fee for paying your loan off early.

FAQs on loan principal

While the definition of loan principal is easy enough to understand, the prospect of agreeing to borrow money can bring up a number of additional questions related to borrowing and paying back the loan. You’ll find answers to several of the most frequently asked questions below.

Can I pay off my principal before interest?

Yes, you certainly can if you’d like by making payments that you specifically indicate should be allocated toward the loan principal balance. That said, under normal circumstances, your monthly payment is typically apportioned out between principal and interest. However, you can make an extra payment and ask your lender to apply the funds to the principal. In essence, certain lenders may allow principal-only payments.

What happens when I pay the principal on a loan?

Doing so serves to lower the total amount in interest charges that you will owe over time. It may also translate into regular savings in the form of lower monthly charges. The amount of money that you pay in interest each month is based on your total principal balance. In other words, the lower your principal, the less that you’ll pay in monthly interest charges.

Is it better to pay interest or principal?

The faster you can pay down your principal balance on a fixed-rate loan, the less that you’ll owe in total interest charges over time. Doing so could help benefit you and your finances. At the same time, not everyone can afford this, and certain principal payments may not be tax deductible, which may impact your tax saving strategies.

The bottom line: The loan principal’s financial impact

For simplicity’s sake: The principal balance on any given loan statement describes how much is left on the original amount of money that you’ve borrowed. Interest describes money that you owe you current lender for servicing the loan, and these charges can be lowered the more that you choose to pay down your principal.

Noting this, certain borrowers elect to pay down their principal balance as quickly as possible to minimize monthly charges and save overall on interest payments. If you can afford to make the extra payments, paying off your principal early could save you hundreds or even thousands in total charges.

Interested in borrowing money? Rocket Loans offers unsecured, fixed-rate personal loans in amounts ranging from $2,000 - $45,000. To see what interest rates you prequalify for, you can start the application process today.