What Is a Loan Principal?

Questions and Answers on How Loan Principal and Interest Works

How Principal and Interest on a Loan Work
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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 the interest is the charge for the time you have the loan. 

The word "principal" means "main." The principal (main) thing to remember about principal as it relates to loans, mortgages, and investments, is that the principal is the major (main) part of the balance of that account. 

The principal of a loan is the amount you borrowed and have to pay. the interest is what the lender charges for lending you the money. 

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 you agreed to. 

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 main part, the original amount invested; for bonds, the principal is the original amount of the bond (its face value).

An Example of Principal and Interest on a Business Loan

Let's look at an example. You take out a loan to buy some business equipment. 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, the principal balance zero and the interest is zero.

Loan Calculators

Want to calculate the principal and interest payments on a loan? 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. 

A "principal only" payment reduces the principal but not the interest. An "interest-only" loan payment does not draw down (reduce) the principal.

Can I Pay Off 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.

How Does Loan Principal Affect My Business Taxes? 

The principal and interest on a loan affect your business taxes differently:

The principal amount of a loan is the amount you paid for the asset (a company car or building, for example). The price of an asset is depreciated (spread out) over the lifetime of the asset.

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 recent 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. See this article from the IRS ("Interest on Home Equity Loans Often Still Deductible Under New Law."

Article Sources

  1. Consumer Financial Protection Bureau. "On a mortgage, what's the difference between my principal and interest payment and my total monthly payment?" Accessed Dec. 7, 2019.

  2. U.S. Consumer Financial Protection Bureau. "What is included in the monthly auto loan payment." Accessed Dec. 7, 2019.

  3. investor.gov. "Principal." Accessed Dec. 7, 2019.

  4. Financial Industry Regulatory Authority (FINRA). "Bond Basics." Accessed Dec. 7, 2019.

  5. Legal Information Institute. "Mortgage." Accessed Dec. 7, 2019.

  6. The Law Dictionary. "What is Additional Principal Payment?" Accessed Dec. 7, 2019.

  7. IRS. "Instructions for Form 8990." Accessed Dec. 7, 2019.