Principal

Principal
The principal is the amount of money that is borrowed through a loan. The term also refers to the amount of money that is left on the loan after payments have been made.

What is the Principal?

When you take out a loan, the principal is the amount of money that you are borrowing. As you make payments on your loan, the principal amount decreases. Aside from the principal, the other important portion of a loan is the interest.[1]

What is interest?

Whereas the principal is the amount of money borrowed, the interest is the amount of money that the borrower is being charged for the act of borrowing. Basically, the amount of interest charged is the cost of the loan.[2]

How does the Principal affect the interest?

Interest is usually expressed as a percentage of the principal over a certain period of time. A bank loan with a 10 percent yearly interest rate would cost the borrower 10 percent of the principal over the course of one year. On the other hand, a title loan with a 25 percent monthly interest rate (which is standard) would cost 25 percent of the principal for every month that the loan is outstanding.

Since the amount of interest charged almost always depends on the size of the principal, the interest is usually referred to as the “interest rate”. With payday loans, the interest rate is often phrased as a certain dollar amount per $100 borrowed.[3] So a payday loan with a $15 per $100 interest rate and a $300 principal would charge $45 in total interest.

How is the Principal paid off?

Paying off the principal depends on the structure of the loan. For instance, title and payday loans are designed to be repaid in one lump sum. (This is difficult for many borrowers, which is one of the reasons these kinds of loans have been labelled as predatory).

With a typical installment loan, the principal is paid off in a series of regular payments.[4] There is a pre-set loan term, oftentimes anywhere from 6 to 60 months, and there is also a pre-set payment schedule, usually monthly. In this type of structure, the payments are all of equal size. In many cases, this structure is also amortizing.

What is amortization?

Amortization is a certain type of a loan structure in which each payment goes towards both the principal and interest. In addition, these payments are all regularly scheduled and are of equal size.[5]

Under an amortizing structure, the first payment goes primarily towards the interest, with only a small fraction of each payment going towards the principal. However, with each successive payment, that ratio changes a little: The fraction of the payment going toward the principal increases and the fraction going toward the interest decreases. By the time the loan has reached its final payment, that amount is going almost entirely towards the principal.

Taking out an amortizing loans guarantees that every payment the borrower makes is paying down the principal. While this might seem obvious, it actually isn’t a given for all loans. And since the interest charged is usually determined as a percentage of the principal, having an amortizing loan can save you money. The smaller the principal, the smaller the amount charged in interest.

With a non-amortizing loan, there is no guarantee that your payments are paying off the principal. And if that is the case, if your payments are only going towards the interest, then you’re not seeing any reduction in the amount you owe or the amount of interest being charged. This type of structure is common with payday and title loans, especially when borrowers “rollover” the loans to gain an extension on the due date.[6]

How do origination fees affect the Principal?

These kinds of fees can be confusing for many borrowers. An origination fee is a fee that’s charged by the lender for processing a loan application, or “originating” the loan. Essentially, it’s a fee for the work and due diligence that goes into approving and issuing a loan in the first place. Origination fees are deducted straight from the principal amount. This results in people receiving less money than they had originally agreed upon. For instance, a person takes out a $5,000 loan but they only receive $4,900.[7]

Origination fees, like interest, are commonly expressed as a percentage of the principal. This means that the more you borrow, the higher your origination fee. When taking out a loan, it’s always a good idea to check for origination fees and to see how much that fee will reduce the principal. With lending and borrowing, surprises are rarely welcome.

What is the Principal for a line of credit called?

Lines of credit work differently than regular loans. Instead of receiving a lump sum of money, a line of credit authorizes a “credit limit”, which is the maximum amount of money that the borrower can access. The borrower is then free to borrow any amount of money between $0 and that credit limit. The borrower only owes interest on what they have borrowed, not on the full amount authorized.

With a line of credit, the principal is referred to as “the balance.” There are two kinds of lines of credit: standard and revolving.[8]

What is a standard line of credit?

With a standard line of credit, the balance does not replenish as the borrower pays it off. For instance, if the borrower has a $5,000 credit limit and then borrows $2,000, they have $3,000 left that they can borrow. However, if they then make a $500 payment on that $2,000 balance, they still only have $3,000 left that they can access. Even though their balance is now at $1,500, they cannot re-borrow the $500 that they just paid off.

What is a revolving line of credit?

With a revolving a line of credit, the balance does replenish as it is paid down. To return to the previous example, making a $500 payment on the $2,000 balance would open up an additional $500 against the $5,000 credit limit. They would now have a $1,500 balance and $3,500 left until they reached the $5,000 max. This is a “revolving balance.” Credit cards operate as revolving lines of credit.

References:

  1. Murray, J. Loan “Principal Questions and Answers.” Accessed July 12, 2016 BizTaxLaw.com
  2. Pritchard, J. “What Is Interest? How Interest Works With Everyday Loans.” Accessed July 12, 2016 Banking.com
  3. “How Payday Loans Work.” Accessed July 12, 2016 PaydayLoanInfo.org
  4. “Installment Loan.” Accessed July 12, 2016 BusinessDictionary.com
  5. “Amortization.” Accessed July 12, 2016 Investopedia.com
  6. “What Does it Mean to Renew or Roll Over a Payday Loan?” Accessed July 12, 2016 ConsumerFinance.org
  7. “Origination Fee.” Accessed July 12, 2016 Investopedia.com
  8. “What are the Differences Between Revolving Credit and a Line of Credit?” (2014, November 6). Accessed July 12, 2016 Investopedia.com