What Is a Loan Principal?
Questions and Answers on How Loan Principal and Interest Works
If you or your business borrow money from a bank or other lender, you have a loan. The payments on a loan are divided into two parts: the principal and the interest. The principal is the amount you are borrowing and have to pay back, and the interest is the extra charge for the loan that accrues over time.
The word "principal" means "main." It is the main part of the balance for loans, mortgages, and investments.
Loan Principal and Monthly Payments
The principal amount on your loan or mortgage is only one part of your monthly payment. The lender includes interest on the loan and other charges. In an auto loan, for example, you might have credit insurance charges or other optional add-ons to which you agreed.
Your monthly payment on a mortgage may include other payments in addition to the principal and interest. For example, many mortgages include homeowner's insurance and property taxes, which are held in escrow by the lender and are paid when they are due.
In a loan amortization schedule, the principal and interest are separated, so you can see which part of your monthly payment goes to paying off the principal, and which part is used to pay interest.
Principal on Investments
In the same way as a loan, investments have principal and interest. The principal amount of an investment is the original amount invested, and for bonds it is the original amount of the bond (its face value).
Example of a Principal in Business
Let's look at an example. You take out a loan to buy some business equipment, and the cost of the equipment is $10,000, but you are contributing $2,000 in a down payment, so the principal on the loan will be $8,000. The bank charges 4% interest on the loan.
When calculating the monthly payments, the bank amortizes the loan, spreading it out over time and calculating each monthly payment. For each month, the schedule shows (a) the principal balance at the beginning of the month, (b) the total amount of the payment, (c) the portion of the payment that goes to reducing the principal, (d) the amount of the payment that is interest expense, and (e) the principal balance at the end of the month.
You will notice that each month the principal balance goes down and the interest amount goes down. By the end of the loan, both the principal and the interest balances reach zero.
If you want to calculate the principal and interest payments on a loan yourself, Mycreditunion.gov has several financial calculators you can use, including calculators for both consumer loans and mortgage loans.
Mortgages: A Special Kind of Loan
A mortgage is a special kind of loan for a property (a home or a building, for example). Normally, you pay both principal and interest on a mortgage. Mortgages are regulated by both federal or state law, depending on what type of institution is making the mortgage. Federally chartered credit unions, for example, are regulated by federal law.
With a mortgage, you can make principal-only and interest-only payments. A principal-only payment reduces the principal but not the interest. An interest-only loan payment pays down interest and does not draw down (reduce) the principal.
Paying the Loan Principal Faster
Most mortgages and loans allow borrowers to make additional principal payments to pay off the loan faster. Paying off the principal faster shortens the loan length.
Check your mortgage document to make sure there is no pre-payment penalty for paying off the loan before the expected payoff date.
Effect on Business Taxes
The principal and interest on a loan affect your business taxes differently.
The interest you pay each year on business loans can be deducted as a business expense on your business tax return for that year. The 2017 tax law changes (Tax Cuts and Jobs Act) include a limit on interest expense deductions that might affect your business.
Individual taxpayers cannot take a tax deduction for the principal on consumer loans, but they may be able to deduct interest on home equity loans under the new tax law.
Consumer Financial Protection Bureau. "On a Mortgage, What’s the Difference Between My Principal and Interest Payment and My Total Monthly Payment?" Accessed Jan. 19, 2020.
Consumer Financial Protection Bureau. "What Is Included in the Monthly Auto Loan Payment." Accessed Jan. 19, 2020.
Cornell Law School: Legal Information Institute. "Mortgage." Accessed Jan. 19, 2020.
The Law Dictionary. "What is Additional Principal Payment?" Accessed Jan. 19, 2020.
IRS. "Interest on Home Equity Loans Often Still Deductible Under New Law." Accessed Jan. 19, 2020.