When an entity borrows an amount as a loan, it must repay it. This amount is known as the principal. If you or your business borrows money from a bank, the funds received is the principal.
To reduce the principal, you have to keep making payments on the loan. Some of that payment will pay off the interest accrued on the principal balance.
Let’s learn how the loan principal affects your monthly payments to make wise decisions when taking a loan and while repaying it.
The amount that someone borrows from a bank is the loan principal, be it for your credit card balance, a car, or a mortgage. For example, if you borrow $2,500 to buy a car, your loan principal is $2,500.
The word ‘Principal’ actually means “main.” So, it is the main part of the balance for loans, mortgages, and investments.
The loan principle helps the borrowers get more specific details about their debt. The debt’s overall balance includes the principal and the interest that accrues on this amount. This balance then also includes charges that the lender imposes, and sometimes the borrower’s total monthly payment could also include additional costs such as taxes.
You can track which part of your payment is being used to pay off the principal and the interest when both are separated. This is known as the loan amortization schedule. As you make payments to the lender, the principal keeps reducing until it's completely paid off.
Let’s understand this from a simple example. You take a loan to buy camera equipment for your photography business. The cost of the equipment is $10,000. Your contribution is $2,000 as a down payment. The principal on loan will be $8,000, while the bank charges an interest of 4%.
Starting the next month, your principal is $8,000, but you now also have an interest balance of $27 ( $8,000 * ( 4% / 12 ). Let's say you make a monthly payment of $500. Out of that payment, $27 pays off your interest balance, while the remaining $473 goes towards reducing your principal. After making this payment, your loan principal is now just $7,527.
When the bank calculates the loan, it amortizes it, which means that it is now spread out over time. This schedule helps you understand how the loan will impact your future finances, including how long it will take to pay off the loan principal and how much of the monthly payments go toward the principal and interest.
Let’s say a large loan is amortized, then the bulk of the monthly payment initially goes towards reducing the interest rather than reducing the principal. This is because you owe more interest when the principal amount is large.
As your monthly payments reduce principal, the interest charges also reduce. Later, the monthly payments go towards reducing the principal. Your monthly payment will give details about how these payments are split.
Let’s take another example to see how this works. John Smith borrows $10,000 at a 6% fixed interest rate in October. John will then repay it in monthly installments of $193 over a five-year term. Let’s look at John’s principal and how it will go down over the first few months of the loan.
As you can see, the 6% as interest applies to only the outstanding principal each month. As John continues making payments and paying the original amount, more of his payment going go towards repaying the principal. So we see that the lower your principal balance, the less interest you will be charged.
While you could make the common mistake while accounting basics of loans of taking the monthly payment as an expense, you should see the initial loan as a liability and then the subsequent payments as –
Let’s go back to John’s $10,000 loan. As John takes that loan and receives the principal amount, the entry shows the following –
John’s first payment of October recorded as –
The $143 reduces the liability of the loan on John’s balance sheet, the $50 is an expense in the Profit and Loss Statement, and the cash credit reflects the payment coming out of John’s checking account.
If John books the original amount as a liability but then books each $193 monthly payment as the expense of the loan, at the end of the year, John’s liabilities would be overstated on the balance sheet, and the expenses would be overstated on the Profit and Loss statement.
If these errors aren’t corrected before John files for his tax returns, the company might underpay the tax it oweas for the year. If the bank wants to see his financial statements before approving another loan application or renewing a line of credit, the overstated liability will impact its decision.
If you are worried about paying off a large amount as interest, there's good news. You can actually make additional payments to the lender to help pay off your loan quicker. These extra payments will reduce the interest you have to pay over the loan's duration since the interest is calculated on the outstanding loan balance.
With a mortgage, let’s say you can make principal-only and interest-only payments. The former reduces the principal but not the interest. On the contrary, an interest-only loan payment reduces the interest, but it does not reduce the principal. However, always check your mortgage or loan documents to ensure there are no pre-payment penalties.
Let’s say that John pays an additional $100 towards the loan’s principal with the monthly payment. He will keep on reducing the amount of interest that he pays over his loan's duration by $609 and shorten the five-year loan term by almost two years.
If you decide to pay your loan even sooner, talk to the lender and find out how they apply for extra payments. Some lenders automatically apply for any extra payments first, rather than applying for the principal payments first.
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