A personal loan can be a helpful financial tool when someone needs to borrow money to pay for things like home repairs, a wedding, or medical expenses, for example. The principal amount of a loan refers to how much money is borrowed and has to be paid back, aside from interest.
Keep reading for more insight into how a personal loan works, what the principal of a loan is, and how it affects repayment.
Table of Contents
Key Points
• The loan principal is the original amount of money borrowed that must be repaid, separate from interest.
• Interest is calculated based on the principal amount, meaning you pay the most interest at the beginning of the loan when the principal is highest.
• As an amortized loan is repaid, less of each payment goes toward interest and more goes toward reducing the principal balance.
• Borrowers can pay down the principal faster by making extra principal payments or refinancing to a shorter-term loan with a potentially lower interest rate.
• The loan principal is not typically considered taxable income.
What Is Loan Principal?
Loan principal meaning is fairly simple: When someone takes out a loan, they are borrowing an amount of money, which is called the “principal.” Principal comes from the Latin word principalis, which means “first” or “original.” The principal is what the borrower agrees to pay back. The interest on the loan is what they’ll pay in exchange for borrowing that money.
All loans, including personal loans, come with a principal amount. Whenever a borrower makes a personal loan payment, the loan’s principal decreases incrementally until it is fully paid off.
Recommended: Guide to Personal Loans for Beginners
Loan Principal vs Interest
The loan principal is different from its interest. As noted above, the principal is the amount of money that was borrowed and must be paid back. The lender will charge interest in exchange for lending the borrower money. Interest is charged as a percentage charged based on the principal. Payments made by the borrower are applied to both the principal and interest.
As the borrower sends more payments and makes progress paying off their loan principal amount, less of their payments will go toward interest and more will apply to the principal balance. This process is known as amortization.
How Loan Amortization Works
Many forms of loans are amortized, including personal loans and mortgage loans. In the beginning of a loan’s term, you owe the most interest because your principal is at its highest. As you make your payments, the principal amount will be reduced so that, by the end of the payment term, most of your payments will be going to pay off the principal.
What Is an Amortization Schedule?
A fixed-rate loan will come with an amortization schedule, a chart showing each scheduled payment on your loan, what your principal balance is before and after the payment, and how much of the payment goes to the loan principal vs. interest. (Variable-rate loans can be amortized, too, but as the interest rate changes over time, the payment amount will change as well.)
Why Early Payments Go Toward Interest
If you look closely at the amortization schedule for a fixed-rate loan, such as a personal loan, you can see the portion of your loan payment that goes toward interest shrinking over the months and years that you pay off the loan. As we’ve seen, this is because interest is calculated based on the principal balance, and that balance is at its highest in the first years of a loan. This front-loading of interest benefits lenders by helping to ensure that they are paid the interest you owe even if, midway through the term, you decide to pay off the loan in full.
How Can You Pay Down the Loan Principal Faster?
It’s understandable that some borrowers may want to pay down their loan principal faster than originally planned as it can save them money on interest and lighten their monthly budget. Here are a few ways borrowers can pay down their loan principal faster.
Make Extra Principal Payments
When a borrower pays down the principal on a loan, they reduce how much interest they need to pay. Personal loan lenders often allow borrowers to make extra payments or to make a larger monthly payment than planned. When doing this, it’s important that borrowers confirm that their extra payments are going toward the principal balance and not the interest. That way, their extra payments work towards paying down the principal and lowering the amount of interest they owe.
Shorten the Loan Term
Refinancing a loan and choosing a shorter loan term can also make it easier to pay down a personal loan faster. Not to mention, if the borrower has a better credit score than when they applied for the original personal loan, they may be able to qualify for a lower interest rate, which can make it easier to pay down their debt faster. Having a shorter loan term typically increases the monthly payment amount but can result in paying less interest over the life of the loan and paying off the debt faster.
Refinance
Refinancing to a new loan with a lower interest rate may reduce monthly loan payments, depending on the term of the new loan. With lower monthly scheduled payments, borrowers may opt to pay extra toward the principal and possibly pay the loan in full before the end of its term.
Loan Principal Repayment Penalties
As tempting as it can be to pay off a loan as quickly as possible to save money on interest payments, it’s important to understand whether or not this will result in a prepayment penalty before paying off a loan early. Prepayment penalties aren’t used by all lenders, however. When shopping for a personal loan, for example, it’s important to inquire about extra fees like this to have a true idea of what borrowing money may cost.
A borrower’s personal loan agreement will state if they will need to pay a prepayment penalty when paying off their loan early. If a borrower finds that they are subject to a prepayment penalty, it can help to calculate which will cost less: paying the prepayment fee or continuing to pay interest for the loan’s originally planned term.
Loan Principal and Taxes
Personal loans aren’t usually considered to be a form of taxable income so the amount borrowed is not subject to taxes like investment earnings or wages are. Generally, borrowers aren’t required to report a personal loan on their income tax return, no matter who lent the money to them (bank, credit card, peer-to-peer lender, etc.). The exception? If some or all of a loan balance is forgiven, this may have tax repercussions.
Recommended: What Are the Common Uses for Personal Loans?
Other Important Information on the Personal Loan Agreement
A personal loan agreement includes a lot of helpful information about the loan, such as the principal amount and how long the borrower has to pay their debt. The more information the borrower has about the loan, the more strategically they can plan to pay it off. Here’s a closer look at the information typically included in a personal loan agreement.
Loan Amount
An important thing to note on a personal loan agreement is the total amount the borrower is responsible for repaying.
Loan Maturity Date
A personal loan’s maturity date is the day the final loan payment is due.
Loan Interest Rates
The loan’s interest rate and APR (annual percentage rate) should be listed on the personal loan agreement.
Monthly Loan Payments
The monthly loan payment amount will be listed on the personal loan agreement. Knowing how much they need to pay each month can make it easier for the borrower to budget accordingly.
APR vs. Interest Rate
Along with the interest rate, a lender may also disclose the APR charged on the loan, which includes any fees the lender might charge, such as an origination fee, and the interest.
The Takeaway
What is the principal amount of a loan? The principal on a loan is the amount the consumer borrowed and needs to pay back. The interest owed on a loan is computed based on the principal. Understanding how a personal loan works can make it easier to pay one off.
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FAQ
What is the principal balance of a loan?
The principal of a loan is the amount originally borrowed that the borrower must repay. Loan principal meaning can be a bit confusing, as the term “principal balance” is often used to refer to what remains of the original loan amount after payments have been made.
Does the principal of the loan change?
The original loan principal does not change. The amount of the principal included in each monthly payment will change as the amortization period progresses. On an amortized loan, less principal than interest is paid in each monthly payment at the outset of the loan. The proportion incrementally shifts over the life of the loan until at the end of the term, the borrower is mostly repaying the principal.
How does loan principal work?
The loan principal represents the amount borrowed. Usually, you will repay the principal in monthly payments until it is fully repaid, with interest.
What happens to the principal if you make extra payments?
If you make extra payments on a loan and direct your lender to apply these payments to the principal, the principal will be reduced.
Is loan principal the same as loan balance?
The terms loan principal and loan balance are often used interchangeably to mean the amount you borrowed from a lender. But the “principal” is the amount you initially borrowed, while the “balance” is what you still owe. You might see these terms qualified further. For example, “original principal” can refer to the amount you initially borrowed, while “outstanding principal” (or “principal balance”) is what remains of the amount you borrowed after you have made some loan payments.
About the author
Jacqueline DeMarco
Jacqueline DeMarco is a freelance writer who specializes in financial topics. Her first job out of college was in the financial industry, and it was there she gained a passion for helping others understand tricky financial topics. Read full bio.
Photo credit: iStock/cagkansayin
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