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What’s the Difference Between Principal and Interest?

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Principal Amount and Interest

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Generally speaking, any kind of loan or financial products bought from a bank and/or a financial institution include a fee of some kind. These fees are found especially in loans, whether it be personal loan, home loan, auto loan, or any other loan for that matter, there is a principal balance, and an interest fee included.

Principal balance is the amount of money you originally agreed to pay back, this does not include the interest, while the interest fee is the cost of borrowing the money from a bank or financial institution.

 

Understanding Principal and Interest

Principal balance is the original sum of money borrowed. If you take out a $10,000 loan, for example, the principal is $10,000. If you pay off $5,000, the principal balance now consists of the remaining $5,000.

This loan amount may vary depending on what the bank or financial institution offered you, most often, banks offer a wide array of loan products available to you with varying amounts depending on your credit score.

The amount of interest you pay on a loan is determined by the principal. For instance, if your loan has a principal amount of $10,000 and an annual interest rate of 4%, you will have to pay $400 per year. 

Interest is the fee of lending you money, which also comes in different amounts. You will also notice that there is a slight difference from interest rates that banks offer, so it is always better to check out every loan available to you, within your credit score, the amount of interest to pay back, and its monthly payments.

According to the Consumer Financial Protection Bureau, even after you check out your principal balance and interest payments, depending on the type of loan you acquired, your monthly payment may include other fees such as a homeowners insurance if you took out a mortgage from a mortgage lender, eligible property taxes, basic government taxes depending on which state you are in. 

There is always a difference in government taxes so that is also one other thing to be mindful about whenever taking out loans, so ask away everything you want to know from your mortgage lender. The interest you pay may not be the only fee you will be charged so scrutinize your loan application.

 

Calculating Interest Payment

Now that you have an idea of what principal payment and interest rates are, it is time to know how to calculate for the interest you pay.

Multiply your principal balance to your annual percentage rate or APR then divide it by 12 months = your monthly interest payments.

Principal Balance x Annual Percentage Rate / Months = Monthly Interest Payment 

So, for example, if you have a $15 000 loan at 6% APR, the calculation would look like this:

[15,000 * (.06)] \ 12 = $75.00

The $75 is only your monthly interest payments so if you have a $15 000 loan and you only paid $75 per month during the whole loan tenure, then you only paid for the interest and you haven’t paid for the total amount of your principal balance. Payment of the principal depends on your commitment with the bank, either you pay it by lump sum or in subsequent payments.

 

How to Manage Paying Principal and Interest Balances

  • Interest-Only Repayments

Interest-only repayments are a type of mortgage that allows a mortgagor or a borrower to repay the principal in lump sum on a specified date or through subsequent payments depending on your contract, and requires the borrower to only pay the loan interest for a certain period of time. 

If the interest-only term expires, the mortgagor or borrower has a couple of options, either you refinance your loan, this means that there is a chance for new terms and even lower interest payments, or sell the home mortgaged to pay off the loan. 

If the term expires, the borrower can still make a lump sum payment on the loan’s due date, if you were able to save as much as the principal amount after not paying the principal for the duration of the interest-only term.

Repayment: The tenure is typically from five to ten years but it is only available for certain borrowers with top shape credit.

Suitable for: This type of mortgage repayment is perfect for first-time home buyers as it allows some room on your wallet to avoid large payments brought about by principal-interest repayments. Especially if you are building a career as you tend to increase your monthly income over the years.

The catch is this type of mortgage does not build up any equity in the property as your principal debt will remain intact for the duration of the loan. Unexpected financial problems also makes this type of mortgage prone to blindsiding the borrower. Losing your job, a huge medical expense, or any financial downturn may overturn the advantage that an interest-only mortgage brings.

  • Principal and Interest Repayments

A principal and Interest repayment or principal-interest repayment is a payment scheme that divides the principal balance into equal amounts per month and charges interest, the fee of borrowing money, on the remaining balance per month.

Here is an example of a principal-interest repayment scheme:

  • Principal: $100,000.00
  • Interest Rate or APR: 5.00%
  • Payment Interval: Monthly
  • Number of Payments: 12
MONTH PAYMENT PRINCIPAL INTEREST BALANCE
1 $8,732.64 $8,333.33 $399.31 $91,666.67
2 $8,697.91 $8,333.33 $364.58 $83,333.34
3 $8,663.19 $8,333.33 $329.86 $75,000.01
4 $8,628.47 $8,333.33 $295.14 $66,666.68
5 $8,593.75 $8,333.33 $260.42 $58,333.35
6 $8,559.02 $8,333.33 $225.69 $50,000.02
7 $8,524.30 $8,333.33 $190.97 $41,666.69
8 $8,489.58 $8,333.33 $156.25 $33,333.36
9 $8,454.86 $8,333.33 $121.53 $25,000.03
10 $8,420.14 $8,333.33 $86.81 $16,666.70
11 $8,385.41 $8,333.33 $52.08 $8,333.37
12 $8,350.69 $8,333.33 $17.36 $0.04
TOTAL: $102,499.96 $100,000.00 $2,500.00 0.00

Repayment: As you will notice, this type of payment scheme will have the same amount of principal payment each month but a diminishing interest balance over time. The monthly payment will also remain more or less stable for the duration or term of the loan but it will also decline over time. This above example is a $100,000 principal loan within a 12-month amortization and a fixed interest rate of 5%.

Suitable for: It may be an enticing method for those who are looking to repay their dues for a short amount of time, while diminishing the amount being paid monthly.

  • Refinancing

Say you are at a loss with your financial engagements and commitments and having a tough time repaying your debt or even just consolidating your finances. Refinancing may be the best way to go. 

Repayment: Typically, refinancing will lower your monthly payments, reduce your interest rate or flip your whole loan program for something that will suit you and your income better.

Refinancing your mortgage may end up reducing your monthly payments, the length of your loan, consolidate your HELOC together with your first mortgage, and switch your interest to a more suitable fixed rate mortgage rather than an adjustable-rate interest.

However, refinancing is not always the best option as it may also increase the duration of your financial engagement. 

Suitable for: Keep in mind that refinancing is only a good option for those who are offered new rates or new terms by your bank.

 

Closing

So, were you able to learn the difference between interest and principal? Along with the different repayment scheme, you should go to your bank’s website for information purposes, don’t forget to accept the website’s cookies for easier transactions on-site in the future.

Share the difficulty of your financial struggles with your close friends as they will take into account their experiences in debt paying. Firsthand experiences are often your best bet in learning about finances, and even life for that matter.