Definition
A principal payment is a payment towards the original amount of a loan that was borrowed, not including interest. This reduces the outstanding balance of the loan. It’s separate from interest payment, which is the charge for borrowing the principal amount.
Key Takeaways
- Principal Payment is a payment towards the original amount of a loan that a borrower has taken, not including interest or additional fees.
- In an amortizing loan, part of each scheduled payment goes towards reducing the principal, while the rest is for interest. More principal is paid off as the loan matures, reducing the loan’s balance more quickly towards the end.
- If borrowers make extra principal payments, they can reduce the total interest paid and can pay off their loans faster. However, some loans might have prepayment penalties for paying off a loan too quickly. It is essential to understand your loan agreement before making extra principal payments.
Importance
The finance term “Principal Payment” is important because it refers to the portion of a loan payment that reduces the outstanding amount of the loan, distinct from the interest paid. In other words, a principal payment directly decreases the size of the loan debt.
Understanding this concept is crucial for effective debt management. It helps borrowers comprehend how their monthly payments are partitioned between reducing the debt and covering the loan’s interest fees.
Moreover, it helps them strategize for faster loan repayment by perhaps making extra principal payments, which can save significant interest costs over the loan’s duration. Hence, the principal payment is a pivotal aspect of managing finances and reducing debt burdens.
Explanation
Principal payment primarily refers to the money used to repay the original sum of money borrowed in a loan. It is critical because it essentially helps to reduce the outstanding balance of a loan, enabling a borrower to gradually pay off their debt. When the borrower pays back more than the interest accrued, the additional money goes towards reducing the principal and thereby aids in cutting down the overall loan duration.
Through such repayments, borrowers not only fulfill their financial obligation but also improve their credit scores over time, facilitating their potential to secure future loans under favorable terms and rates. In terms of its application, principal payment plays a key role in mortgage loans where the monthly payouts typically consist of both principal and interest payments. At the start of a loan period, a large portion of each payment covers the interest, with a smaller part reducing the principal.
However, as the loan matures, the proportion shifts, and more of each payment is applicable to the principal than the interest. This strategy, known as amortization, helps ensure that the loan is gradually paid down over its lifespan. In this way, consistent principal payments ultimately lead to the complete ownership of an asset, such as a home in the case of a mortgage.
Examples of Principal Payment
Home Mortgage: Suppose you took out a home mortgage for $250,000 at a 4% rate of interest for 30 years. Each monthly mortgage payment would consist of a portion towards the interest and a portion towards the principal. The portion that goes towards the principal is the principal payment, reducing the initial amount (or principal) that you borrowed.
Car Loan: If you borrowed $20,000 to purchase a car with an interest rate of 5%, your monthly payments will include both a principal and interest portion. The principal payment would be used to gradually decrease the $20,000 you initially borrowed.
Student Loan: Let’s say you have a student loan of $30,000 with an average interest rate of 6%, repayable over 10 years. Your monthly payments will be split into a portion that covers the accrued interest and a portion that reduces your principal debt. The principal payment is that which is used to pay down the initial $30,000 borrowed.
FAQs on Principal Payment
What is a Principal Payment?
A Principal Payment is the amount of money that is applied to the original amount of a loan that was borrowed. It is a payment that reduces the outstanding principal amount, not including interest.
How does a principal payment work?
When you make a payment on a loan, part of it goes towards the interest accrued and the remainder goes towards reducing the principal. The goal is to eventually pay off the entire principal, at which point the loan is fully paid off.
Can I make additional principal payments?
Yes, most lenders allow you to make additional payments specifically towards the principal. This can reduce the total amount of interest paid over the life of the loan and can potentially shorten the loan term.
How are principal payments calculated?
The amount of a principal payment is typically calculated as the total monthly payment minus the monthly interest cost. This will vary based on the interest rate and the balance of the loan.
What is the difference between principal payment and interest payment?
The principal payment goes directly towards reducing the initial amount borrowed, whereas an interest payment is the cost charged by the lender for borrowing the money. Combined, they constitute your total monthly loan payment.
Related Entrepreneurship Terms
- Amortization Schedule
- Interest Payment
- Loan Balance
- Debt Repayment
- Mortgage Principal
Sources for More Information
- Investopedia: A comprehensive website dedicated to providing free, easy-to-understand information about investing, finance, and market news.
- Khan Academy: A non-profit organization providing free, world-class education for anyone, anywhere. They have lessons on numerous subjects, including finance.
- Bankrate: A leading site that provides free rate information to consumers on more than 300 financial products.
- NerdWallet: A personal finance company that offers advice about credit cards, insurance, loans, and consumer-focused issues.
