When you take out a loan the original amount of money you borrow is called the loan principal. This key term is one of the most important to understand when taking out any type of loan.
What is Loan Principal?
The loan principal refers to the amount of money that is originally borrowed from a lender. It does not include any interest or fees that may be charged on the loan The principal is the basis for calculating interest and monthly payments on a loan.
For example, if you take out a $20,000 auto loan to purchase a new car, the principal amount is $20,000. This is the amount that you actually receive and can use to buy the car. As you make monthly payments over the loan term, a portion of each payment goes towards repaying the principal.
The principal balance decreases over time as the loan is paid off. Your monthly payments will be calculated based on the original principal amount, interest rate, and loan term.
Key Features of Loan Principal
Here are some key things to know about loan principal:
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The principal never changes. The original loan amount remains the same over the life of the loan.
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Principal versus interest – Your monthly payments go towards both repaying principal and paying interest. In the early stages of repayment, more interest is paid. As the balance decreases, more money goes toward principal.
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Prepayment can reduce principal – Making extra payments or paying off the loan early reduces the principal balance This saves on interest costs over the long run
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Minimum payments repay some principal – Even just making the minimum monthly payments gradually repays a portion of the original principal over time.
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Principal determines loan amount – The principal is used to calculate the maximum loan amount you can qualify to borrow based on factors like income, debts, and credit score.
Examples of Loan Principal
The concept of loan principal applies to any type of loan product:
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Mortgages – For a $300,000 home mortgage, the principal is $300,000. Monthly payments go toward interest and principal to pay off the loan over 15 or 30 years.
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Auto loans – A $15,000 new car loan has a principal amount of $15,000. The term may be 3-6 years to repay the principal plus interest.
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Personal loans – An unsecured $10,000 personal loan used to consolidate credit card debt has a principal of $10,000 paid back over a set term.
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Student loans – A student who borrows $30,000 in federal loans has a total principal debt of $30,000 to be repaid over 10-25 years.
Why Loan Principal Matters
It’s important to understand loan principal because it determines the true cost of borrowing money. The principal amount, length of the loan term, and interest rate all factor into the total interest paid over the life of the loan.
A higher principal generally equals higher total interest costs. However, even a lower principal loan can become expensive if the interest rate is high or the repayment term is very lengthy.
When shopping for a loan, pay attention to not just the interest rate but also how the principal amount may impact your monthly payments and overall costs. A loan calculator can help determine payments and total interest based on the loan details entered.
Carefully consider whether it makes sense to borrow the maximum principal you qualify for or if you can get by with a lower principal loan. Avoid borrowing more than you can comfortably afford to repay each month.
Tips for Managing Loan Principal
Here are some tips to make the best use of your loan’s principal amount:
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Avoid spending loan funds on non-essential purposes – Only use the principal for the intended purpose like paying college tuition or medical bills.
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Make extra principal payments – Paying even $20-50 extra towards principal each month can make a big dent in the total interest paid.
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Refinance or consolidate loans – You may be able to get a lower rate to reduce interest costs on the principal.
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Ask about principal reductions – Some lenders may offer programs to forgive or reduce principal, especially for student loans.
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Pay more than the minimum – Paying the minimum only repays a tiny fraction of principal each month. Pay extra whenever possible.
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Create a repayment strategy – Have a plan for repaying the principal within the loan term to avoid extending the loan and owing more interest.
The Bottom Line
When you boil it down, the loan principal is the heart of any loan transaction. All other loan terms stem from the original principal borrowed. Carefully consider the principal amount when taking out a loan and have a solid game plan to repay this amount within the set loan term. Keeping close tabs on your outstanding principal balance is key to paying off your loan successfully while minimizing interest costs.
Example of a Term Loan
A Small Business Administration (SBA) loan, officially known as a 7(a) guaranteed loan, encourages long-term financing. Short-term loans and revolving credit lines are also available to help with a company’s immediate and cyclical working capital needs.
Maturities for long-term loans vary according to the ability to repay, the purpose of the loan, and the useful life of the financed asset. Maximum maturity dates are generally 25 years for real estate, up to ten years for working capital, and ten years for most other loans. The borrower repays the loan with monthly principal and interest payments.
As with any loan, an SBA fixed-rate loan payment remains the same because the interest rate is constant. Conversely, a variable-rate loans payment amount can vary since the interest rate fluctuates. A lender may establish an SBA loan with interest-only payments during a companys startup or expansion phase. As a result, the business has time to generate income before making full loan payments. Most SBA loans do not allow balloon payments.
The SBA charges the borrower a prepayment fee only if the loan has a maturity of 15 years or longer. Business and personal assets secure every loan until the recovery value equals the loan amount or until the borrower has pledged all assets as reasonably available.
Understanding Term Loans
Term loans are commonly granted to small businesses that need cash to purchase equipment, a new building for their production processes, or any other fixed assets to keep their businesses going. Some businesses borrow the cash they need to operate on a month-to-month basis. Many banks have established term loan programs specifically to help companies in this way.
Business owners apply for term loans the same way they would any other credit facility—by approaching their lender. They must provide statements and other financial evidence demonstrating their creditworthiness. Approved borrowers get a lump sum of cash and are required to make payments over a certain period of time, usually on a monthly or quarterly repayment schedule.
Term loans carry a fixed or variable interest rate and a set maturity date. If the proceeds are used to finance the purchase of an asset, the useful life of that asset can impact the repayment schedule. The loan requires collateral and a rigorous approval process to reduce the risk of default or failure to make payments. As noted above, some lenders may require down payments before they advance the loan.
Borrowers often choose term loans for several reasons, including:
- Simple application process
- Receiving an upfront lump sum of cash
- Specified payments
- Lower interest rates
Taking out a term loan also frees up cash from a companys cash flow in order to use it elsewhere.
Variable-rate term loans are based on a benchmark rate like the U.S. prime rate or the London InterBank Offered Rate (LIBOR).
How Principal & Interest Are Applied In Loan Payments | Explained With Example
FAQ
What is the original amount of a loan called?
What is the term of a loan amount?
What does it mean to term out a loan?
What was the original amount of the loan?
What are loan terms?
Loan terms refer to the terms and conditions involved when borrowing money. These include the loan’s repayment period, the interest rate and fees associated with the loan, penalty fees that borrowers might be charged, and any other special conditions that may apply.
Is a loan term the same as multiple loan terms?
No. Loan terms refer to the various parts of a loan like the interest rate, penalty fees, and repayment schedule. The loan term, singular, refers to the length of time that you have to repay the loan. Understanding the difference between loan terms is crucial, as they can significantly impact how much you pay on your loan over time. Familiarize yourself with the terms early.
What is the principal of a loan?
The principal of a loan refers to the original principal on a new loan or the principal remaining on an existing loan. This calculator assumes interest compounding occurs monthly as with payments. Other factors include the annual nominal interest rate and the number of payments required to repay the loan.
What is the interest on a loan?
The interest on a loan is the amount that the bank charges for lending you the funds. The interest is calculated differently depending on the type of loan. For example, shorter term, fixed-rate loans like personal loans use a simple interest calculation, while longer-term loans like mortgages and some auto loans are amortized.