In loans, the principal is the amount that an entity borrows and must repay. If you or your business borrows money from a bank, you have a loan, and the size of your loan is the initial principal. As you make payments on the loan, part of those payments will reduce the principal, while the rest will pay off the interest that has accrued on the principal balance.
Learn how loan principal affects your monthly payments, as well as your taxes, so you can make the most of your debt.
What Is Loan Principal?
Loan principal is an amount that someone has borrowed. This applies to all forms of debt, whether it's a credit card balance, a car loan, or a mortgage. If you borrow $3,000 to buy a car, for example, your initial loan principal is $3,000.
The word "principal" means "main." It is the main part of the balance for loans, mortgages, and investments.
Loan principal allows borrowers to get more specific about their debt. The debt's overall balance includes the principal as well as the interest that has accrued on that principal. The balance could also include fees and charges imposed by the lender, and a borrower's total monthly payment could include additional costs such as insurance or taxes.
As a borrower makes payments to the lender, they will reduce the principal, until it is eventually erased entirely. 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.
How Loan Principal Works
Consider this basic example. You take out a loan to buy some business equipment, and the cost of the equipment is $10,000. You contribute $2,000 as a down payment as you open the loan, so the initial principal on the loan will be $8,000. The bank charges an annual interest rate of 4%.
Next month, your principal is still $8,000, but you now also have an interest balance of $27 ($8,000 x (4% / 12)). You make a monthly payment of $500. Of that payment, $27 pays off your interest balance, while the remaining $473 goes toward reducing the principal. After making the payment, your loan principal is now $7,527.
When calculating the monthly payments, the bank amortizes the loan, spreading it out over time. This creates a schedule that allows you to know exactly how the loan will impact your finances, including how long it will take to pay off the principal, how much of your monthly payments go toward the principal, and how much of your payments go toward the interest.
When a large loan is amortized, the bulk of your monthly payments will initially go more toward reducing interest rather than reducing the principal. That's because you'll owe more interest when your principal is large. As your monthly payments chip away at the principal, the interest charges shrink, and more of your monthly payments go toward reducing the principal. Your monthly statement will detail exactly how your payment is split.
Effect on Taxes
For Individuals. Individual taxpayers may be able to deduct the amount they pay for loan interest each year, depending on the type of loan. Many mortgage interest and student loan interest payments qualify for this deduction. Payments toward your principal balance, however, are not tax-deductible.
For Businesses. The principal amount of a business loan is only part of the amount you paid for the business asset (a company car or building, for example). The total amount you paid (called cost basis) includes any down payment, costs to buy the asset, and other initial costs. You can depreciate this cost (spread it out) over the lifetime of the asset, giving your business tax deductions over this period. Businesses can also write off interest expenses paid each year, with some limitations.
Principal on Investments
You may also hear the term principal referred to in the context of investments. As opposed to the amount borrowed, an investor's principal is the amount of money they put into an investment.
If the investment is a bond, the investor may receive interest payments on the principal investment. If it's a stock, the investor may hope to experience capital gains on the value of their investment, so the stock eventually becomes worth more than the principal investment.
Paying the Loan Principal Faster
Most mortgages and loans allow borrowers to make additional payments to pay off the loan faster. With a mortgage, for example, 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 reduce the principal. Paying off the principal faster shortens the loan length. Check your mortgage or loan document to make sure there is no pre-payment penalty for paying off the loan before the expected payoff date.
- The loan principal is the amount that has been borrowed.
- Throughout the lifetime of the loan, the borrower will make payments that reduce the principal until it reaches $0.
- In addition to paying off the principal, a borrower will also make payments to reduce their interest balance.
- A business may be able to depreciate the principal amount as part of the cost of a business asset and take a deduction on loan interest each year.
- Individuals can't write off the loan principal as the cost of a loan, but they may be able to write off interest expense on a loan, with some limitations.