What Does Loan Principal Mean? A Simple Guide to Understanding This Key Loan Term

Taking out a loan can seem confusing, with all the financial jargon thrown around. Terms like “interest” “fees,” and “principal” get tossed around a lot. But what does loan principal actually mean?

In this comprehensive guide, we’ll explain the loan principal definition in simple terms, so you understand this foundational concept when borrowing money.

The Basics: Loan Principal Definition

First, let’s start with a straightforward loan principal definition:

The loan principal is the amount of money you originally borrow from a lender. It’s the core sum of cash you agree to receive upfront and pay back over time through your loan payments.

For example

• You take out a $20,000 auto loan to buy a new car. The loan principal is $20,000.

• You get approved for a $200,000 mortgage to purchase a home The loan principal is $200,000

• You finance $15,000 in college tuition with a student loan. The loan principal is $15,000.

The principal is the basis of the loan. It’s the raw dollar amount you owe at the outset, before interest charges, fees, insurance, and other costs get added on top.

All the other fees and expenses stem from the original loan principal sum.

Key Characteristics of Loan Principal

To fully understand the loan principal concept, it helps to break it down even further:

• The amount borrowed from the lender when initiating the loan
• The core balance you owe, not including interest or fees
• As you pay down the loan, the principal decreases over time
• Making payments does not reduce the original loan principal amount

Let’s explore each characteristic in more detail:

Initial Amount Borrowed

When you first take out a loan, the principal is the upfront lump sum of money you receive and agree to pay back. This original loan principal stays the same over the full lifetime of your loan.

For example, if you borrow $300,000 for a mortgage, that initial amount borrowed is your principal. Even after making payments for 10 years, the original principal remains $300,000.

Core Balance Owed

The current loan principal balance is the remaining amount you still owe on the original principal at any given time.

As you make loan payments, the outstanding principal decreases, but the original stays the same. The principal owed right now is your current principal balance.

Declines as You Make Payments

Each monthly loan payment reduces your outstanding principal amount. The goal is to completely pay off the loan by decreasing the principal balance to zero.

For example, after a year of mortgage payments on that $300,000 loan, your current principal balance might now be around $295,000.

Original Amount Doesn’t Change

This brings up an important note: Making payments does not alter the original loan principal.

Even after paying your loan for years, the initial amount you borrowed (the original principal) remains static. It’s only the remaining principal balance owed that declines with each payment.

So in our example, the original principal stays $300,000. Only the current principal balance changes.

Real-World Examples of Loan Principal

To make the loan principal concept even more concrete, let’s walk through some real-world examples using common loan types:

Mortgage Loan Principal

• Maria takes out a $250,000 mortgage to buy a house
• The original principal on Maria’s home loan is $250,000
• After 5 years and making payments, Maria’s current principal balance is $225,000
• The original principal still remains $250,000 even though her balance is now lower

Auto Loan Principal

• James finances $30,000 for a new truck with an auto loan
• His original principal is the $30,000 he borrowed initially
• After 3 years of monthly payments, James’ current principal balance is $18,000
• His original principal is still $30,000 on his car loan

Credit Card Principal

• Lisa has a $5,000 balance on her credit card
• The $5,000 balance is the loan principal she owes on her credit card debt
• If Lisa pays $1,000 toward her balance, her new principal is $4,000
• The original principal was $5,000, but her current principal declines as she pays

How Principal Differs From Other Loan Costs

Along with understanding what loan principal means, it’s also helpful to know how it differs from other costs that factor into your total loan payments:

• Interest – The fee charged by the lender to borrow the principal. It’s typically expressed as an annual percentage rate (APR).

• Fees – Additional charges like origination fees, application fees, or prepayment penalties required by the lender.

• Insurance – Some loans (like mortgages) require insurance, which gets added to the monthly payments.

• Taxes – Property taxes and other taxes can be included in loan payments, like with a mortgage.

The principal is the actual amount borrowed. Interest, fees, insurance, and taxes are extra costs tacked on by the lender, on top of the principal sum.

How Monthly Loan Payments Apply to Principal

Now that you understand what loan principal is, how do your monthly payments actually impact the principal balance?

With most loans, a portion of each payment goes toward reducing the principal owed. This gradual “chiseling away” at the principal is known as amortization.

Here’s a general overview of how it works:

• Your monthly payment is divided between principal and interest

• Initially, more goes toward interest because your principal is high

• Over time, as the principal shrinks, more goes toward principal

• In the end, nearly all the payment goes to principal

Let’s say you have a $200,000 mortgage with a monthly payment of $1,000. Here’s how amortization may work:

Month 1:

• $800 goes to interest
• $200 goes to principal
• Principal balance is now $199,800

Month 120:

• $50 goes to interest
• $950 goes to principal
• Principal balance is now $100,000

As you pay down your loan, less interest is charged each month since the principal declines. That allows more dollars to flow toward knocking down the principal.

How Lenders Determine Loan Principal Amounts

Lenders decide how much principal to offer borrowers based on:

• Credit – Your credit reports and scores help indicate your repayment risk. Better credit means bigger loans.

• Income – Lenders look at your income, employment, and ability to afford payments. Higher earners get larger principals.

• Debt-to-income ratio – Lenders calculate your total monthly debt payments divided by gross monthly income. The lower your DTI, the more you can borrow.

• Down payment – The more you put down upfront, the lower risk you are for the lender. Bigger down payments allow larger loan amounts.

• Assets – Your savings, investments, real estate equity, and other assets help qualify you for bigger loans.

• Collateral – Loans secured by an asset, like mortgages, qualify for higher principals since the lender can seize the home if you default.

The more “creditworthy” you appear, the more principal money a lender will offer on your loan.

The Takeaway: What Loan Principal Means

Hopefully this breakdown demystifies the key concept of loan principal. To recap:

• It’s the upfront amount you borrow from a lender

• This original principal stays the same over the loan term

• Your current principal balance goes down as you make payments

• Interest, fees, and other costs get added on top of the principal

• Monthly payments chip away at reducing your outstanding principal

So the next time you’re reviewing loan documents or statements, you’ll know exactly what that principal amount refers to so you can be an informed borrower.