Loan Principal Definition And Basics

When you take a loan from a lender, you encounter terms like principal loan, interest, and so on. Understanding these terms, especially loan principal, is essential as it directly impacts your monthly payments and the repayment schedule overall. 

In simple words, the principal loan amount is the value of the original money borrowed. The interest amount and all other fees are calculated based on this amount and additionally charged.

What is Principal On A Loan?

When you borrow money from a lender, the principal amount is the actual money that you are offered and agree to repay. However, the total amount that you need to repay includes the interest and various fees. The total costs depend on the principal or principal loan. This means that borrowing less gets a lower rate of interest. Additionally, with timely payments, the principal balance of the loan reduces. If the principal is paid off early, the total costs are reduced.

Principal Loan Definition

The term ‘principal’ is a Latin word that means ‘first in importance’. When you take a loan, the original amount borrowed is the principal. It’s the basis of calculating other essential parameters of the loan, such as the interest, fees, etc. The principal amount also impacts the amortization schedule. The principal balance is lowered if you are charged an origination fee, which is usually adjusted from the loan proceeds.

Comparing Principal & Loan Principal Interest

To start with, principal is the money borrowed from the lender. Interest is the amount that you are charged by the lender for giving you the loan. 

There are two types of interests that lenders charge:

1. Simple Interest is where lenders charge interest on principal balances.
2. Compound Interest is where the interest applies on the principal balance and the outstanding interest.

Points to remember -

1. Higher interest rates result in a greater amount of interest paid.
2. There are ways to get loans at lower interest rates. For example, you can improve your credit score, compare interest rates, improve your creditworthiness, and so on.

Note: Your creditworthiness has a longstanding bearing on the rate of interest on your loan. It can also impact the monthly principal loan payment and total borrowing cost. Even though there are many other factors affecting the interest rate, your credit score is the most important.

How Does Principal Payment Work?

To better grasp the definition of loan principal, here's an example. 

Let’s say that Mary has taken a personal loan of $20,000 at a 10% interest rate for five years. The lender agreed to charge simple interest on the loan. She was also not charged any origination fee. In this case, Mary needs to pay an interest amount of $2,000 accrued for the first year, provided the principal balance does not change during this term. 

In this case, the amortization schedule is set up so that the same amount needs to be paid off every month. 

The payment amount has two parts. One part is used for settling the interest, the other part in reducing the original principal amount.

The good thing is that Mary’s total monthly payment remains the same for the entire term of five years, irrespective of what percentage goes towards the principal payment and interest. 

In this example, the maximum interest is adjusted during the initial part of the loan’s tenure. This is also the time when the principal debt is the highest. In this case, the first payment instalment of $424.94 is split into two parts - the former part of $166.67 goes towards paying the interest, and $258.27 goes towards the principal.

With subsequent payment of the mortgage principal, the accrued interest lessens throughout the month. Gradually, towards the end of the loan term, the monthly interest payment becomes minimal and the principal loan payment is the maximum. For example, by the 59th month, the interest amount reduces to $5.99 and the principal amount reaches $411.95.

In other words, the principal payment split out between repayment of the principal and interest payment changes over time. While initially the split features major payment of the interest and principal amount repayment, towards the end of the loan, this reverses. At the later stages, most of the monthly payment helps settle the principal amount, while the interest amount reduces considerably.

Therefore, to decrease the loan amount, you should -

• Ensure that you make the monthly payments on time. The principal balance will reduce with every subsequent monthly payment.
• The interest payments can be paused temporarily by forbearance or deferment. Remember, the interest will continue to accrue. This is the capitalization of the interest, which means that the pending interest is added to the principal balance.
• Speak with your lender/creditor to modify the terms of the loan permanently. This is especially true when you are facing issues in repaying the loan. This is called loan modification. In such cases, the monthly repayment amount decreases. This is done either by increasing the loan term or the rate of interest is decreased.

There is also the case of negative amortization where the total loan balance increases with time. This happens when the monthly payment is not enough to cover the accrued interest.

Why Is It Important To Make Monthly Payments of the Principal Amount In My Loan?

By paying off the principal amount, the principal balance is decreased. Also, making the monthly payment is crucial to pay off the entire loan. 

Lenders allow you to pay an additional amount to further reduce the principal balance of your loan. By choosing this principal-only payment model, your monthly payment will remain the same and the accrued interest will decrease, helping you save money and also settle the loan faster. 

Note: You may be penalized for prepaying the loan in part or completely. You can do this either by paying directly or by refinancing. It is advised that you read the loan agreement thoroughly before taking the loan to understand your options.

FAQs

What is loan principal?

Loan principal is the original amount of money you borrow from a lender. The base loan amount used to purchase the home, not including interest, taxes, homeowners insurance, mortgage insurance, or other fees.

For example, if you buy a home for $300,000 and put down a $60,000 down payment, your mortgage principal would be $240,000. As you make monthly mortgage payments, part of each payment goes toward reducing your principal balance, while another part goes toward interest.

What is the difference between loan principal and interest?

The principal is the amount you borrowed, while interest is the cost of borrowing that money. Your monthly mortgage payment typically includes both principal and interest. Early in the loan term, a larger portion of your payment usually goes toward interest. Over time, as your principal balance decreases, more of your payment goes toward paying down the loan itself.

This process is called amortization, which means paying off a loan through regular payments over time.

What benefits more: paying principal or escrow?

Paying extra toward your principal usually helps reduce your loan balance and helps you pay off your mortgage faster. It also lowers the total amount of interest you pay over the life of the loan.

Adding extra money to your escrow account does not directly pay down your mortgage principal. Escrow is used to help cover costs like property taxes and homeowners insurance. While keeping your escrow account funded is important, it does not reduce the amount you borrowed. The CFPB (Consumer Financial Protection Bureau) notes that taxes and insurance may be included in the total monthly payment, but they are separate from the principal and interest used to repay the loan.

How is loan principal calculated?

Loan principal is calculated by subtracting your down payment from the purchase price of the home.

For example:

Home price: $300,000

Down payment: $60,000

Mortgage principal: $240,000

In this case, $240,000 is the amount borrowed from the lender. That amount becomes your starting principal balance. From there, your monthly payments gradually reduce the balance over time.

What is included in a total monthly mortgage payment?

A total monthly mortgage payment often includes more than just a principal and interest. Most mortgage payments include PITI, which stands for:

Principal - the amount borrowed

Interest - the cost of borrowing

Taxes - property taxes

Insurance - homeowners insurance, and sometimes mortgage insurance

Depending on the loan type, down payment, and lender requirements, your monthly mortgage payment may also include private mortgage insurance or other escrowed costs.

Can you pay extra toward your mortgage principal?

Yes. Many borrowers choose to make extra principal payments to reduce their mortgage balance faster. This may help shorten the loan term and reduce the total interest paid over time.

It’s important to make sure the extra payment is applied as a principal-only payment. Otherwise, the servicer may apply the funds differently.

Does your principal balance go down every month?

In most standard mortgage loans, yes. Each monthly payment usually reduces the principal balance, but the amount going toward principal changes over time. At the beginning of the loan, more of your payment typically goes toward interest. Later in the loan term, more of your payment goes toward principal.

This is part of the mortgage amortization process, where the loan is gradually paid down through scheduled payments.

Is the mortgage principal the same as the loan balance?

They are closely related, but not always exactly the same. The original mortgage principal is the amount you borrowed at closing. Your current loan balance, or outstanding principal balance, is the amount you still owe after making payments.

For example, if your original mortgage principal was $240,000 and you have paid down $20,000, your remaining principal balance would be $220,000.