When you choose to take on a loan, whether it is secured or unsecured, one of the top questions you may ask is “how much interest will I pay?” Adding all your monthly payments up will yield a total that includes both principal and interest.
The loan principal is a key part of loan terminology, so understanding what is meant by the principal amount at the beginning of your process as well as throughout your loan will help you make smart financial choices. You can also make extra payments toward the principal on many kinds of loans, an option that can help you pay off your loan early.
What is a principal amount?
The principal on a loan refers to either the entire amount of the loan when it is first taken out, or the amount of the original debt that remains. It is contrasted sometimes with the interest that is paid on the loan, since all of your payments over time will add up to be all of the interest due plus the total principal of the loan.
If you have paid off $2,000 of the principal of a $5,000 loan, you’ve probably also paid quite a lot of interest and you’ll have interest left to pay, but the principal of the loan has been reduced to $3,000.
[ See: How to Calculate Your Loan Payments ]
How do loan principals work?
Your loan principal reduces each time you make a payment, but it doesn’t decrease by the full amount of your payment. If you are making a payment of $500 on a loan each month, you might be paying, for instance, $100 of interest due to the size of the loan. That means that only $400 is applied to the principal of the loan, meaning that it reduces the total amount you owe compared to what you originally borrowed.
While some lenders charge a fee for paying back the principal earlier than the schedule of payments, other lenders allow you to make extra payments for free. If you were to pay $1,000 on the above-mentioned loan, you’d be making your normal payment ($100 in interest, $400 in principal), but you’d also be able to apply the remaining $500 directly to the principal, since you are paying early.
Loan principal vs. loan interest
In most loans, you’ll be responsible for paying a portion of the interest each month in addition to making a dent in the principal. Knowing the difference is important: the principal is the money that you received from the lender, which you pay back in full over the life of the loan. The interest is based on the amount of the loan, length of the loan and interest rate — and this amount will change slightly if you make any early payments.
Is interest tax deductible on a personal loan?
Interest is rarely tax deductible on personal loans, though there are a few exceptions. If the loan was for education or business expenses, there are times when the interest will become tax-deductible. If you take out a personal loan that you use to buy certain investments and are a person who itemizes your deductions, you might also be eligible for an interest tax deduction, but in general, your personal loan interest won’t be a tax deduction.
[ Read: What is a Personal Loan? ]
How to calculate loan principal payments
Over the life of a loan, the percentage of your payment that is interest will go down, and the percentage that is principal will go up.
For example, say you take out a $5,000 loan at 5% interest for five years. The lender will calculate how much interest you’ll owe over time, spread it out over the life of your loan, and divide the combined principal and interest into equal monthly payments. The schedule created is called an amortization schedule.
In an amortization schedule, you’ll pay $94 every month, but at the beginning, that payment will be only $73 in principal and $21 in interest. Over time, your remaining principal goes down, so the assessed interest will also go down. By the last payment, you’re only paying $0.40 in interest because you have such a small remaining principal.
How to pay to the principal
If you’ve chosen to pay over and above your monthly payment schedule on a loan, you can often make an extra payment that goes entirely toward the principal. Here’s how:
- Check with your contact at your lender about its procedures for paying ahead on the principal. The lender may point out that there is a small fee or a special way to make that additional payment, or it may indicate you can simply write a larger check or make a larger e-payment. The additional money will be applied to the principal.
- If you determine that the prepayment penalties on your loan are too high to make it worthwhile, consider opening a high-yield savings account and saving any money you wanted to apply to the principal; you can pay out of that account once you’ve saved up an amount equal to the rest of your payment schedule, effectively ‘paying off the loan early’ without having to pay the prepayment penalties.
- If you do choose to pay on the principal early through your lender, keep track of how many payments you are removing from the end of the schedule. Sometimes paying ahead can be a great feeling, since you are shortening the time you’ll be in debt to this lender.
Let’s say that you have that previously-mentioned, five year, $5,000 loan, and you make a $94 payment every month. If you choose to double your payment for the third month, you’ll reduce the total number of payments from 60 down to 59. What’s even better is that you actually make a little more progress than that, since there will be less time for interest to accrue. Paying ahead on the principal means that, over the life of the loan, you pay less total interest to have received the loan.
[ Next: How to Pay Off Your Car Loan Early ]
Does inflation impact the principal?
Inflation, when a given unit of currency can buy less than it did in the past, tends to benefit borrowers. Inflation is not entirely predictable, but with a fairly stable, low-inflation currency, lenders make interest rate decisions with an eye to expected rates of inflation. Overall, however, buying something with a loan now rather than waiting five years to save up to pay in cash is to your benefit for inflation, since you buy with “now dollars” rather than the depreciated future ones.
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