What is Principal and Interest?

One of the most common questions consumers ask is this: what is principal and interest? They’re both terms related to loans, but what do they mean?

We believe that financial literacy is a core component of achieving financial empowerment. And understanding principal and interest is key to paying off debt. So let’s take a look at what these terms mean and how understanding them can save you some money!

What Is Principal?

The principal refers to the loan amount when you take out a loan. As you pay this amount back, the amount you still have to repay is also known as the principal.

For example, if you take out a loan of $100,000, your principal is $100,000. If you pay back $50,000, assuming no interest, your remaining principal is $50,000.

What Is Interest?

Interest is essentially the cost of borrowing money. When a bank loans you money, they do so with the aim of making a profit. And that charge is expressed as a percentage of the principal, usually an Annual Percentage Rate (APR).[1] [2]

An Annual Percentage Rate is expressed as a percentage rate, but the rate is on an annual basis. For example, if you have an APR of 5% on a loan, that means you pay 5% of the principal every year as interest. That may not seem like a lot, but it can stack up.

For example, if you take out a $500,000 mortgage for thirty years to buy a home at a 5% APR, your total interest charges over thirty years will be $466,278, or almost as much as the mortgage principal! Even though the APR is only 5%, that adds up over the course of the loan.

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How Often Does Interest Get Calculated?

While the interest rate may be expressed as an APR, it is calculated on a monthly basis for most loans. Each month, the lender will calculate your APR and add interest charges based on the remaining principal. The good news is as you pay down your principal, your interest charges will also decrease.

How Are Interest Rates Determined?

In addition to knowing what is principal and interest, it’s important to know a bit more detail about interest rates themselves. The Federal Reserve, the central bank of the United States, sets the federal funds rate, which is the target rate for banks to make loans to each other. The Fed manages this rate to control inflation. It’s a balancing act lowering the rate tends to encourage financial activity but leads to higher inflation, raising the rate can help control inflation but at the risk of slowing down economic growth since financing things becomes more expensive. Banks base their best rates on the federal funds rate, and the Wall Street Journal tracks these rates, calculates, and publishes the resulting average as the ‘prime rate.’

The interest rates offered to consumers use this rate as a baseline. There are two types of interest rates offered:

A fixed rate is a set rate that stays consistent from month to month. While banks can increase this rate if the borrower fails to make timely payments or even when rates go up, they generally provide notice.
Variable rates rise and fall with the prime rate and are usually expressed as a percentage above prime. The time between rate changes can vary; some variable rate loans recalculate interest rates monthly, quarterly, or annually.

The rate any given borrower will be offered for a loan can vary widely, based on the type of loan, the borrower’s credit history , the amount borrowed, and the prime rate at the time the loan was established.

How Are Payments Allocated?

It is important to know how principal and interest work to understand how your payments are allocated and make optimal decisions for your financial situation. Payments toward a loan are applied to interest charges first and then towards principal only after interest charges are paid. Principal payments are also available, where an additional or separate payment is made by the borrower with specific instructions that the payment go towards the principal.

Because interest compounds monthly on most loans, the principal often drops slowly, if at all, based on the normal payment. How does this affect your loan? Let’s find out.

Mortgages

A mortgage usually has a fixed payment for the life of the loan. When you sign for the mortgage, you’re committing to making equal monthly payments for fifteen or thirty years, depending on your loan term. Payments early in the mortgage term usually reduce your principal very slowly. This is because you’re paying interest on nearly the full amount of the loan and only a small portion of the payment reduces that principal. You might only be paying a few dollars a month on the principal after covering the interest. However, every dollar you pay toward principal will, in turn, reduce your interest.

This means that a 15-year mortgage results in far less interest overall, even though the monthly payments are higher. It also means that if you can pay extra toward your mortgage each month to knock down the principal, you can dramatically reduce the amount of time it takes to pay off the mortgage.

Credit Cards

Credit cards generally offer a low minimum payment – usually just enough to cover the interest charges. However, because there’s no fixed term, making the minimum payment does very little to reduce your credit card debt. In order to pay off credit card debt, you have to commit to paying higher than the minimum payment to reduce the principal. If you have a tight budget and can’t afford to pay much, just remember that every dollar you pay over the minimum helps knock down the principal, saving you money in the long run.

How Much of my Payment Goes To Interest?

You can calculate your monthly interest payment using the following formula:

[Principal balance x (APR)] / 12 = monthly interest payment.

For example, if you have a $20,000 loan at 5% APR, the calculation would look like this:

[20000 x (.05)] / 12 = $83.33

In this example, the first $83.33 of your monthly payment would go to paying the interest, and anything after that would get allocated to principal.

Let’s say you make a $183.33 payment that month. You’d calculate your next month’s interest as follows: [19,900 x (.05)] / 12 = $82.91

This may not seem like a lot, but it adds up. You’ll pay the loan off much faster, and with far lower total interest charges.

With a mortgage, it becomes even more evident. For example, let’s say you just closed on a $500,000 mortgage for a new home at a 5% APR. (For the purposes of the example, we’ll ignore things like property taxes, fees, and mortgage insurance.) You have a mortgage payment of $2,684 for thirty years.

Your first month’s interest charges will be as follows: [500,000 x (.05)] / 12 = $2,083.33

Only about $600 will be applied to the principal. In your first year, you’ll pay $24,832 in interest charges and only $7,376 toward your principal.

How Can I Use This Information?

If you can afford to pay more than your minimum monthly payment, that amount goes directly to principal. Over the course of the loan, that will make a huge difference. Even paying biweekly instead of monthly can make a big difference. For example, if you pay $1,342 every two weeks instead of $2,684 per month, paying part of the mortgage earlier reduces your interest charges more quickly and knocks four years off the total time to pay off the home…and $85,000 off the total interest charges you’ll have to pay.

If you’d like to see what this looks like with your own mortgage, try using a mortgage calculator! Choose the ‘show amortization tables’ option to see a visual depiction of how your payment allocation affects your interest charges and time it takes to pay the mortgage off.

One smart move, especially if you have several credit card or loan balances, is to consider a debt consolidation loan. That way, you have fewer loans to focus on and can focus on making principal payments.

Now that you know what principal and interest are, we hope you can use this information to help save money, make financially empowered decisions, and continue to prosper!

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