What Is the Principal of a Loan? Understanding How Loan Repayment Works

The amount that you initially borrow when taking out a loan is called the principal. As a borrower, you're responsible for paying back the principal plus any interest and fees as stated in your loan agreement.

If you have an existing loan, you'll want to understand how the loan principal affects payments. Here's what you need to know about loan principal, including tips for paying down the loan principal faster.

What is the principal of a loan?

The initial principal on a loan is the amount of money you initially borrow from a lender. You must repay this amount, typically in installment payments, over an agreed-upon period. As you make payments toward your loan, this principal amount gets smaller. When you're in repayment, the reduced principal amount is called your outstanding or unpaid principal.

However, as a borrower, the principal amount isn't the entirety of what you owe the lender. You'll also owe interest, and possibly fees, as your cost of borrowing.

How does the principal affect your loan payments?

One way loan principal affects your loan payments is through the monthly installment amount that's due. To determine how much principal you owe each month, the initial loan principal is divided by the number of months in your loan term. For example, if you borrowed $15,000 over five years (60 months), the principal amount due each month is $250, plus interest and any applicable fees.

If your initial principal is higher — say, $45,000 — your monthly loan payment will increase, assuming your interest rate and fees don't change. In this scenario, you'd pay $750 in monthly principal installments, plus interest and fees.

Principal vs. interest: What's the difference?

Principal and interest are two factors used in calculating your loan's monthly payment. The principal is how much money you've borrowed from the lender. Conversely, interest is how much the lender charges you as the cost of borrowing money. Interest is expressed as a percentage, and the interest charged each month is based on the principal you owe.

The two common types of interest calculations are:

• Simple interest: The interest rate is calculated against your original loan amount.
• Compound interest: The interest is calculated using your unpaid principal and any unpaid interest from prior months. For example, outstanding interest from missing a payment is added to your next payment, and you'll pay interest on your interest.

“The principal impacts the loan in several ways,” says Tom Alessi, president of ARIES Foundation for Financial Education, Inc. “Total interest paid, the amount of your monthly payments, and how the amortization schedule is set up to handle repayments of principal and interest.”

When you first start making loan payments, your outstanding principal is higher, which means your interest charge is also higher. As a result, a greater portion of your initial loan payments go toward paying the interest each month than the principal. This process is called amortization. As you make more payments, a greater portion of the payment is applied to your principal.

This is why paying down the loan principal faster is always ideal. “Paying down a loan faster with extra payments is the No. 1 way to avoid paying interest over the life of the loan,” says Steve Hill, a mortgage broker at SBC Lending.

“I explain it to people this way: The longer you're in the loan, the better it is for the bank; the faster you're out of the loan, the better it is for you,” he adds.

Strategies for paying down the loan principal faster

One strategy for paying down the loan principal faster is making half payments every two weeks, according to Josh Miller, head of consumer acquisition, marketing, and product development at KeyBank.

“This can lead to one extra payment a year, which reduces the outstanding principal balance faster — meaning lower interest costs and paying off the loan faster,” explains Miller.

Other ways to strategically lower your unpaid loan principal early include:

• Make extra principal-only payments: Pay more than the minimum amount due each month. Miller suggests rounding up your minimum monthly payment. “The extra amount generally will be applied directly toward principal and lower your interest costs, allowing the loan to be paid off faster,” he says.
• Refinance: Refinance your loan to access a lower interest rate, which can accelerate your principal payoff. Just keep in mind that you'll generally need strong credit to qualify for a lower rate.
• Choose a shorter loan term: A shorter repayment term means you'll repay a larger chunk of the principal each month.
• Verify how extra payments are applied: Some lenders apply extra payments toward interest instead of putting these payments toward the principal. Contact your lender to confirm that all extra payments — no matter how big or small — are applied directly to your loan principal.

How principal repayment works for different types of loans

Consumer loans, like conventional mortgage loans, student loans, car loans, and personal loans, all work similarly when it comes to principal repayment.

“All installment loans are generally calculated the same way,” says Hill. “The exception would be interest-only loans like a HELOC that are calculated differently. With a regular installment loan, the principal is paid down with each payment.”

Most installment loans have an amortization schedule since the borrower and lender have agreed on a fixed repayment term, and a portion of principal and interest are equally divided over the loan's term.