The loan principal is the amount of money that you borrowed and agreed to pay back. On why you took out a loan, there is only one reason – lack of funds. That being the case, it is in your best interest to understand this term, as it is one of the keys to clearing your debt. After all, you want to pay the loan off sooner rather than later.
What Is a Loan Principal?
A loan principal is one of the constants that you encounter whenever taking out a loan. The others include interest and other fees associated with the loan.
It does not matter which type of loan you took out, such as:
- Student loans from federal or private institutions
- Business loan
- Car loan
- Credit card balance
- Home loan
- Bridging Loan
So, regardless of which type, the initial amount of money you took is the loan principal. For example, you purchased merchandise that cost $1,000 and charged it to your credit card. The loan principal is $1,000. Do note, however, that the term “principal” is not exclusive to borrowing. This sum of money can is also applicable in investments.
The total debt includes the principal itself, the accrued interest on the unpaid principal, and other lender charges such as:
- Application fee
- Origination fee
- Prepayment penalty
- Late payment fee
- Returned check fee
At any rate, the fees and penalty charges mentioned above are expenses you typically pay before securing the loan or inability to pay as agreed upon.
The monthly payment made, on the other hand, covers only the principal and interest. In some cases, it may also include insurance premiums and taxes. You are essentially reducing the loan principal on each payment while also paying off the accrued interest on the principal balance.
In many types of loans, most lenders provide a loan amortization schedule. Here, you can see that the principal and interest are separate. Each time you pay, you can see how much money goes to the principal and the loan interest. Concurrently, you can also see the outstanding principal balance and the expected interest expense.
How Does a Loan Principal Work?
Calculating the monthly loan principal payment and the amount of interest owed is easy – or complicated.
Here is an illustration to make it easier to understand:
- Loan amount: $10,000
- Annual interest rate: 6%
- Monthly payment: $600
After securing the loan, the money you borrowed is $10,000, which you pay in installments beginning the following month. How do you know which part of the monthly payment goes to the interest and principal amount?
- $10,000 x (6% / 12) = $50
When you pay $600, $50 pays off the principal loan interest. $550 goes to the principal only. As such, the outstanding principal balance is now $9,450 ($10,000 – $550).
As you can surmise, the interest payment for the following month should be lower as the principal goes down.
- $9,450 x (6% / 12) = $47.25
The part of the monthly payment that goes to the principal – $552.75 ($600 – $47.25) – increases.
Over subsequent payments throughout the loan term, you pay more to the principal and less to interest.
You do not have to make all these calculations. In most loan types, the lender provides a loan amortization schedule (and monthly statement) which details, among others:
- Loan term agreement
- Payment schedule
- Principal balance
The example provided in the preceding section is simple and only used to give you an idea of how paying the loan principal works. In some loan types, such as a mortgage loan, it is more complicated. The main reason for that is other expenses such as property taxes, homeowner’s insurances, and homeowner’s association fees in the monthly payments.
Here is an example:
- Home price: $330,000
- Down Payment: 20% ($66,000)
- Length of loan: 30 years
- Interest rate: 2.98%
- Property tax: $217
- Homeowner’s insurance: $66
In this case, the computation for the monthly mortgage payment would be $1,393, broken down as follows:
- Principal and interest: $1,110
- Property tax: $217
- Homeowner’s Insurance: $66
Again, you do not need to make all these monthly mortgage payment calculations yourself. It would be easier to use free online financial calculators such as this mortgage payment calculator.
How Does Loan Principal Payments Differ from Interest Payments?
A loan principal is the sum of money borrowed from a lender. It is mainly the borrower who determines how much money to loan. The interest, on the other hand, is the cost of borrowing the money. While lenders can adjust the interest rate, they can only do so to a degree as market conditions primarily drive it.
Another factor affecting how much interest you pay is the credit score. Lenders offer lower interest rates to borrowers with excellent credit history. Conversely, they charge borrowers with poor credit scores higher interest rates. Click here to read more on how to improve your credit score.
Choosing a lender offering the lowest interest rate may not necessarily be cheaper overall. That is because you also need to factor in all other loan-associated expenses. A term that you must have seen is APR (annual percentage rate). APR is a more realistic representation of the costs incurred in borrowing money because it combines interest and all other fees.
How Do You Account for Loan Principal Balance?
Labeling a monthly payment for a loan as an expense is a mistake. Instead, the initial loan should be recorded first as a liability. Then, the book should have separate entries on subsequent monthly payments to reduce the principal balance and interest expense.
Going back to the generic example provided earlier, assume that the loan amount is $10,000. In this case, the entry would look like the following:
For the upcoming monthly payment of $600, the first entry would look like the following:
So, how does this work out?
On the balance sheet, the $550 reduces the loan liability. The $50 interest, meanwhile, will reflect as an expense on the profit and loss statement. Lastly, the cash credit will show the payment source, such as a checking or savings account.
What happens if you record entire monthly payments as an expense?
You would overstate the liabilities in the balance sheet and expenses in the profit and loss statement at the fiscal year’s end.
Such practice, especially in a business, might cause an individual or a company to underpay tax. Furthermore, this error on the financial statement might make it challenging to obtain a new loan or renew a line of credit.
How Do You Manage Monthly Payments to Pay Off the Loan Faster?
A fixed interest rate is beneficial because it does not change even if the market increases. Conversely, the flexibility of adjusting monthly payments allows you to pay the loan principal faster. The good news is that in most loans, you do have the option of paying more if you have extra money.
There are many ways you can have more funds to pay off debts. But here are the important things to remember:
- Reduce unnecessary expenses to free up funds for making extra payments.
- Add other income sources to augment your capacity to pay.
When you follow these two principles, there is no reason you cannot pay off your loan quickly. In the process of doing so, you can also save more money in the form of reduced interest. Remember that interest on loan principal accrues over time. Hence, the sooner you pay, the less the interest expense accrues.
Reduce Loan Principal Sooner
The loan principal is an easy-to-understand term. In any debt, you not only pay back the principal but also the interest. With a better understanding of the difference between principal and interest, it should be easier to employ practical strategies to pay off a loan faster.
- The interest in principal accrues over time. The longer it takes to pay a loan, the more interest you pay.
- Monthly payments first pay off the accrued interest before the principal.
- Interest payments decrease on subsequent monthly payments while the portion that goes to the principal increases.