You are actually paying two different things when you make payments on a personal or business loan: principal and interest.
Hereâs a quick rundown of what those terms mean, and how to account for them in your business.
When it comes to paying off your loan, you might be wondering whether it’s better to focus on the principal or the interest first. Both approaches have their pros and cons, and the best strategy for you will depend on your individual financial situation and goals
This comprehensive guide will delve into the intricacies of loan principal and interest, providing you with the knowledge you need to make an informed decision. We’ll explore the key differences between these two components, analyze the advantages and disadvantages of each payoff method, and offer practical tips to help you save money on your loan.
Understanding Loan Principal and Interest
Loan principal: The principal refers to the amount of money you initially borrowed. It’s the core debt that you’re obligated to repay, excluding any accrued interest or fees.
Loan interest: Interest is the cost of borrowing money. It’s typically expressed as an annual percentage rate (APR) and is calculated based on the outstanding principal balance. The higher the interest rate, the more you’ll pay over the life of the loan.
The Impact of Interest on Your Loan
Interest plays a significant role in determining the total cost of your loan. The longer it takes to repay the principal, the more interest you’ll accumulate. Therefore, focusing on paying down the principal as quickly as possible can save you a substantial amount of money in the long run.
Payoff Strategies: Principal vs. Interest
1. Principal-Focused Payoff:
This strategy involves making extra payments towards the principal balance of your loan each month. By doing so, you’ll reduce the amount of interest you’ll pay over the life of the loan.
Pros:
- Saves money on interest
- Shortens the loan repayment period
- Builds equity faster (for mortgages)
Cons:
- Requires larger monthly payments
- May not be feasible for everyone
2. Interest-Focused Payoff:
This strategy involves making the minimum monthly payments and focusing on paying off the accrued interest first. Once the interest is paid off, any additional payments will go towards the principal.
Pros:
- Lower monthly payments
- More manageable for those with tight budgets
Cons:
- Pays more interest over the life of the loan
- Extends the loan repayment period
Choosing the Right Payoff Strategy
The best payoff strategy for you will depend on your financial circumstances and goals. Here are some factors to consider:
- Your budget: Can you afford to make larger monthly payments?
- Your interest rate: A higher interest rate makes it more advantageous to focus on the principal.
- Your loan term: A shorter loan term means less time for interest to accrue.
- Your financial goals: Are you aiming to become debt-free quickly, or do you prioritize other financial goals?
Additional Tips to Save Money on Your Loan
- Make extra payments whenever possible: Even small extra payments can make a big difference over time.
- Refinance your loan: Consider refinancing to a lower interest rate if it’s available.
- Negotiate with your lender: Some lenders may be willing to waive fees or offer other concessions.
- Automate your payments: Set up automatic payments to avoid missing a payment and incurring late fees.
Paying off your loan effectively requires a strategic approach. By understanding the difference between loan principal and interest, analyzing the pros and cons of each payoff method, and considering your individual circumstances, you can choose the strategy that best suits your needs and saves you money in the long run.
Accounting for loan principal
When accounting for loans, one of the most frequent errors is to book the entire monthly payment as an expense instead of initially recording the loan as a liability and then recording the subsequent payments as:
- partly a reduction in the principal balance, and
- partly interest expense.
To illustrate, letâs return to Hannahâs $10,000 loan. Hannah’s books would show the following when she obtains the loan and gets the money:
| Debit | Credit |
|---|---|
| Cash | $10,000 |
| Loan Payable | $10,000 |
Hannahâs first loan payment in August should be recorded as follows:
| Debit | Credit |
|---|---|
| Loan Payable | $143 |
| Interest Expense | $50 |
| Cash | $193 |
Hannahâs Hand-Made Hammocksâs balance sheet will show a lower loan liability of $143, its profit and loss statement will show an expense of $50, and the checking account of Hannahâs Hand-Made Hammocksâ will show a credit to cash.
At the end of each year, Hannah’s liabilities would be overstated on its balance sheet and its expenses would be overstated on its profit and loss statement if Hannah had initially recorded the entire amount as a liability but later recorded each $193 monthly payment as an expense of the loan. Should the mistake not be fixed prior to Hannah filing her business tax return, the company may underpay the amount of taxes due for that particular year. The overstated liability could have a negative effect on the bank’s decision to approve another loan application or renew a line of credit if they requested to see financial statements.
What is loan principal?
The principal on your loan is the total amount of debt you owe, and the interest rate is the cost to you as a borrower. Interest is usually a percentage of the loanâs principal balance.
You can view a breakdown of your principal balance, the amount of each payment that goes toward principal, and the amount that goes toward interest on either your loan amortization schedule or your monthly loan statement.
When you make loan payments, youâre making interest payments first; the the remainder goes toward the principal. The next month, the interest charge is based on the outstanding principal balance. In the event that it’s a large loan (such as a mortgage or student loan), the interest may be front-loaded, meaning that your payments will be 90% interest and 10% principal at the end of the term.
To illustrate, letâs say Hannahâs Hand-Made Hammocks borrows $10,000 at a 6% fixed interest rate in July. Hannah will repay the loan in monthly installments of $193 over a five-year term. This illustrates how Hannah’s loan principal would decrease during the first few months of the loan.
| Month | Payment Amount | Interest Paid | Principal Paid | Principal Balance |
|---|---|---|---|---|
| July | – | – | – | $10,000 |
| August | $193 | $50 | $143 | $9,857 |
| September | $193 | $49 | $144 | $9,713 |
As you can see from the illustration, the 6% interest rate only applies to the outstanding principal amount each month. Hannah’s monthly payments are going toward principal as she continues to make payments and reduce the initial loan amount. The lower your principal balance, the less interest youâll be charged.