When you take out a loan, you’ll likely hear the term “principal” thrown around a lot. But what exactly does principal mean when it comes to loans? Keep reading this complete guide to find out everything you need to know about loan principal.
What Is Loan Principal?
The principal of a loan refers to the amount of money that was originally borrowed. It’s the base amount that interest and fees are calculated on top of.
For example, if you take out a $200,000 mortgage, the principal of that loan is $200,000. That’s the amount you actually borrowed from the lender
The principal is different from the loan balance, which is the amount still owed. The principal stays the same over the life of the loan (unless you refinance), while the balance goes down as you make payments.
How Does Loan Principal Work?
When you make loan payments, part goes toward interest and part goes toward the principal. In the beginning, most of each payment goes to interest since the principal is still high.
As you pay down the loan, the principal gets lower. This means less interest is charged each month, so more of the payment goes to principal.
For example, let’s say you take out a $200,000, 30-year mortgage at 5% interest. Your monthly payment would be about $1,073.
In the first month, $833 would go toward interest and $240 toward principal. After 10 years and 120 payments, your balance is around $172,000. Now $693 goes to interest and $380 to principal each month.
Over time, more and more of the payment is applied to principal as the balance gets lower.
Where to Find the Loan Principal
You can find the principal amount on any loan disclosure paperwork you received when taking out the loan. This includes:
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Mortgages: The principal will be listed on your Loan Estimate and Closing Disclosure.
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Auto loans: It’s shown on your retail installment contract.
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Student loans: Look at your Master Promissory Note.
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Personal loans: The principal is in your Truth in Lending Disclosure.
The principal is also listed on your monthly statements so you can see how it changes over time. Many lenders let you view this info by logging into your online account too.
Principal vs. Interest
As mentioned above, principal refers to the amount borrowed, while interest is the cost of borrowing that money. You’ll pay interest on the principal over the life of the loan.
Your interest rate is usually shown as a percentage of the principal balance. For example, a 5% interest rate on a $200,000 loan means you’ll pay $10,000 in interest per year.
The higher the principal, the more interest you’ll owe since it’s a percentage of that amount. This is why early in a loan, most of your payment goes toward interest—because the principal is still high.
Loan Principal vs. Loan Balance
While the principal stays the same, the balance changes over time. The balance is the amount still owed on the loan, factoring in any accrued interest and payments made so far.
For example:
- Principal: $200,000
- Balance after 1 year of payments: $195,000
- Balance after 5 years: $180,000
As you make payments, the balance gets lower while the original principal stays the same. The balance may also be higher than the principal if interest has accrued.
How to Pay Off Loan Principal Faster
There are a few ways to pay down your loan principal more quickly:
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Make extra payments: Send in more than the monthly amount due to slash your principal faster. Be sure to specify that you want extra funds applied to the principal only.
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Refinance: You may be able to get a lower rate on your existing loan, reducing interest costs and letting more money go to principal. Run the numbers to see if it makes sense.
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Take out a shorter-term loan: Opting for a 15-year mortgage over a 30-year one means you’ll pay the principal down twice as fast (but have higher monthly payments).
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Make bi-weekly payments: This adds up to an extra monthly payment per year, accelerating payoff. Automate payments to stay on track.
The key is making payments above the required monthly minimum whenever possible so you chip away at the principal faster. This saves on interest costs over the long run too.
The Impact of Loan Principal on Interest
As mentioned, the higher the principal balance, the more interest you’ll owe each month. This relationship drives how loan payments are structured.
In the beginning of a loan, the large principal balance means a big interest payment each month. So most of your early payments go toward interest, with just a small amount left for principal.
But as you pay down the loan, the principal gets lower. This decreases your interest costs for the month, leaving more money to apply to principal.
By the end of the loan, the principal is very low. So your payment mostly goes toward principal, with just a small portion paying interest.
Principal Payments vs. Interest Payments
Another way to think of it is:
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Principal payments: Reduce the amount owed. These shrink the loan balance.
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Interest payments: The cost of borrowing money. These don’t reduce what you owe, but must be paid to avoid defaulting on the loan.
You have to keep making both types of payments until the principal is fully repaid. Many people focus on getting the principal down faster because this reduces total interest costs over time.
Are Principal Payments Tax Deductible?
For individual federal income taxes, interest payments are typically tax deductible, but principal payments are not.
For example, you can deduct mortgage interest payments on Schedule A, but principal payments just reduce your tax basis in the property. Same for student loan interest, which is deductible up to $2,500 per year.
For business loans, principal payments are deducted over time through depreciation. Businesses can also deduct interest expenses. Talk to a tax professional to understand your specific situation.
Common Questions About Loan Principal
Here are some quick answers to common questions on loan principal:
What’s included in loan principal?
Just the original amount borrowed. It does not include any interest, fees, or payments made.
Can you pay extra toward principal?
Yes, most lenders allow extra principal payments. Be sure to specify that’s where you want extra funds applied.
Does principal change?
The original principal never changes. But the remaining principal balance goes down as payments are made.
Where is principal on a statement?
Principal and principal payments are itemized on monthly account statements. The current balance equals remaining principal plus interest.
The Bottom Line
When taking out a loan, the principal is the amount of money you initially borrow. This drives interest costs over the life of the loan. Focusing on principal paydown helps you pay off loans faster and save money.
Now you know the complete basics on what principal means when it comes to loans! Understanding this key term will help you make better borrowing decisions.
Principals As Responsible Parties
The term principal also refers to the party who can transact on behalf of an organization or account and who takes on the attendant risk. A principal can be an individual, a corporation, a partnership, a government agency, or a nonprofit organization in this case. Principals may elect to appoint agents to operate on their behalf.
A principal could be involved in transactions ranging from a corporate acquisition to a mortgage. The principals are usually listed in the transaction’s legal documents. They include everyone who signed the agreement and who therefore has rights, duties, and obligations for the transaction.
An individual who hires a financial advisor is considered to be a principal. The advisor is the agent. The agent follows the instructions given by the principal and may act on their behalf under specified conditions and terms. The advisor is often bound by fiduciary duty to act in the principal’s best interests. The principal is at risk for any action or inaction on the agents part. The principal takes the loss if the agent makes a bad investment.
A problem with the principal/agent relationship can arise when theres a conflict in priorities between a person or group and the representative authorized to act on their behalf. An agent may act contrary to the principals best interests. This can occur in many situations, from the relationship between a client and a lawyer to the relationship between stockholders and a CEO.
| The Various Definitions of Principal | |
|---|---|
| Different Types of Principal | Definition |
| Loans | The sum of money borrowed |
| Investments | The amount of money put into an investment |
| Bonds | The face value of a bond |
| Companies | The owner of a private company, partnership, or other type of firm |
| Transactions | The party that has the power to transact on behalf of an organization or account and takes on the attendant risk, whether an individual, a corporation, a partnership, a government agency, or a nonprofit organization. |
Principal in Bonds
The principal of a bond or other fixed-income investment is the amount the issuer agrees to pay back to the investor upon the bonds maturity. A bonds principal is also known as its par value or face amount because this amount was printed on the face of the bond itself back when bonds were issued on actual pieces of paper.
The bonds principal excludes any coupon, recurring interest payments, or accrued interest although the issuer is obligated to pay these as well. A 10-year bond with a $10,000 face value may be issued and have $50 recurring coupon payments semiannually. The principal is $10,000, independent of the $1,000 worth of coupon payments over the bonds life.
A bonds principal isnt necessarily the same as its market price except when its first issued. A bond may be purchased for more or less than its principal depending on the state of the bond market.