Understanding Your Loan Principal

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Category: Loans
Posted on: 06/22/2021
A couple meeting with a loan officer in an office to review the terms of their contract

Understanding your loan principal is an essential part of successfully navigating the financing process. Every loan has principal and interest, which must be clearly distinguished and understood. If you begin working with financing tools without understanding your loan principal and how it works, you set yourself up for problems later on. 

On the other hand, understanding your loan principal is one of the first steps in successfully navigating the world of financing. That means your top priority must be understanding your loan principal and terms to ensure you know what you’re signing on for. Whether your loan is for a home, vehicle, education expenses, or business, understanding your loan principal is important. This article will fill you in on all the essential details to help you understand your loan principal and get off to a solid financial start.

What is Loan Principal?

Loan principal is essentially the amount of money you borrow from your lender. For example, say you take out a loan for a new vehicle and you are approved for $15,000 in financing, so you decide on a vehicle at that price. This amount, the money you need to borrow to make your purchase, is your principal. Loan principal is a different, smaller amount than what it will ultimately cost you to borrow the money. After all, lenders are not lending you money for free. Instead, they almost always want something in return for going without their money for a time. 

The additional money that it costs you to borrow the principal in the first place is your interest. What interest and principal share is that they both go down as you make monthly payments on your loans. But it is important to understand that your monthly payments will not simply be paying off the amount you borrowed. Instead, each monthly loan payment you make will also be going toward paying off the interest it costs you to borrow in the first place.

Understanding How Loan Principal and Interest Interact

Your loan principal is, generally, the initial amount you wanted to borrow. However, this is not always the case. You may find yourself approved for only part of the amount you want to borrow. In this case, your principal is not the total you want to borrow but is simply the maximum amount you were approved for. The interest is what you will pay in addition to what you borrow in exchange for being able to borrow at all. Interest is, therefore, generally seen as what it costs to borrow. 

Interest payments are usually a percentage of the principal amount, listed as the annual percentage rate or APR. Your APR is based on your lender’s terms as well as your credit history. Of course, other factors in the financial market can also affect your APR. Still, generally, your payments will be lower when your credit score is high, especially if you have a thorough and solid credit history. This is why it is important to keep your credit in mind when trying to secure financing.

The amount of money you borrowed will always be equal to the amount you pay back on your loan principal, but your interest rate can change. That means that the interest costs can vary throughout the life of your loan. So even though your principal total remains the same and payments on it will not vary, your monthly payments could still change. A fluctuating interest rate could cause you to have higher or lower payments each month.

Repaying Your Loan Principal

Repaying your loan principal is often the smaller part of many monthly loan payments, especially at the beginning of your repayment. Early on, the portion of each payment that goes toward interest may account for more of your minimum monthly total than the principal. Much less goes toward your principal each month than you might think! The higher your loan principal is, the higher your interest rate will tend to be. Since the cost to borrow needs to be paid back first, your interest becomes most of your payments. 

Monthly loan payments typically remain the same if you keep up with your payment schedule. That means paying at least the minimum payment each month. While your monthly payments will largely stay the same, their makeup will not. As you continue to repay your loan, a greater proportion of each monthly payment gradually goes to your principal. Less is funneled into interest over time as your principal shrinks. 

The exception to this rule is what are known as “principal-only” payments. Some lenders allow these, but they are typically extra payments after you have paid the minimum due. This lets you make an added payment to cut your principal further and lower your interest for the future. But be careful, since lenders often require you to give them prior notice if you want to apply a payment specifically to your principal or pay down your balance early, and not all lenders offer these payments in the first place. 

You need to know the terms of any loan before signing on, especially if you want the possibility of principal-only payments. Otherwise, you may think you are paying off your principal but are really only making a second regular payment on mostly interest. You can potentially pay off your interest first and then your principal, but this is often a bad idea. Your interest will not lessen over time because your principal will not shrink. This could significantly increase what you pay over the life of the loan.

Figuring Out Your Loan Principal

Figuring out your loan principal is relatively simple once you understand what to look for. You can use any number of online tools to help figure out your loan principal. These tools can be especially helpful when you are considering different loan options. Once you already have a loan, your lender should provide you with updated information on its status. The monthly statement for your loan should give you a total breakdown of your monthly payment and remaining principal balance. It should also detail your interest and any fees or charges you incur. These details are provided as an industry standard for mortgages, auto loans, student loans, and other common types of financing. If any of these details are ever unclear, contact your lender for clarification right away.

Finance Guru

Finance Guru