Loan lingo decoded: what is the principal of a loan?

Demystifying the world of loans is a way for you to gain confidence in your ability to shape your own financial destiny. With a clear understanding of how loans work, you can build your financial smarts, unlock the power to make informed decisions, and manage your debt effectively. We’ll help you unravel a few simple truths and learn the lingo. Let’s start with the principal of a loan.

What is the principal of a loan? 

The principal of a loan is the original sum of money borrowed from a lender. The principal balance doesn’t include interest charges. When you make a loan payment, a portion of the money goes toward paying down the principal balance.  

Breaking down a loan: Principal vs interest

The principal of a loan is the money you borrowed and owe to the lender, while interest is the cost of borrowing money.

The principal of a loan is the amount of money you owe, starting with the original amount you borrowed. As you repay the loan, part of each payment goes toward reducing the principal, while the rest covers interest and any additional costs associated with borrowing.

Interest, on the other hand, is the cost of borrowing money. It’s what the lender charges as long as you still owe a balance. Interest is calculated as a percentage of the principal. A portion of each loan payment goes toward interest charges.

Over time, you'll pay both the principal and interest.

Other components of a loan 

Besides the principal and interest, a loan has two other components you should know about. They are the interest rate and time (the amount of time that you have the debt). (The length of the loan is called the term. Most times, you have the option to pay off a debt ahead of schedule. Your total cost is affect by the amount of time it takes, whether or not that’s the same as the loan’s term.)

Interest rate 

Interest rates are annual figures, but most lenders calculate interest every day or month.

If your rate is 12%, that’s the same as 1% per month or about 0.033% per day.

For most loans, you only pay interest on the amount you still owe, so as you pay down the principal of your loan, the interest charges also go down.

If you were to borrow $100 at 12% interest and pay it off in a single payment at the end of one year, you’d owe $112. 

But most loans are paid off a little bit at a time. Let’s say you make your first payment and it leaves you with a principal balance of $92. In the second month, the lender will only charge you interest on $92. If you pay off this loan in 12 monthly payments of $8.88, you’ll pay about $6.62 in interest.

That’s how personal loans work, as well as car loans and mortgages. (Credit cards are different. They charge compound interest, which means you’ll end up paying a little more.)

Related: How to calculate interest on a loan

Time

As long as you owe, the lender charges interest. So if you pay off the debt faster, you’ll pay less in interest.

Let’s take another look at that $100 loan at 12% interest. If you make the regular payment plus an extra $5 each month, you’ll pay off the debt in 8 months. You’ll only pay about $4.32 in interest.

This is why some financial experts advise borrowers to take a 15-year mortgage term instead of a 30-year mortgage term. You don’t have to double the payment to pay off the loan in half the time. In fact, the payment on a 15-year loan might only be about one-third higher than the payment on a 30-year loan.

Paying back the loan

Loan payments are calculated to pay off the debt entirely, in equal payments, by the end of the loan term. Part of your payment covers the interest that accrued in the last month, and part of your payment goes toward your principal (the balance that you still owe).

What factors can make my loan principal go up?

Your principal balance could increase if interest capitalizes. That means the lender charged interest and you didn’t make a payment big enough to cover it, so the unpaid interest was added to your principal balance. Now the amount you owe is bigger, and the next month, the lender charges you interest on the higher amount.

This could happen when your loan is in deferment or forbearance (when the lender allows you to pause payments). For example, full-time students are typically not required to make payments on their student loans. Private student loans and some federal student loans continue to accrue interest during this time. If you don’t make a payment that’s at least big enough to cover the accrued interest each month, it’ll be added to your principal balance and the amount you owe will get bigger.

There’s also the possibility of being charged various fees, such as for paying late. You have to pay those fees, but they aren’t added to your principal balance and they won’t accrue interest. Certain factors could increase your loan balance, but fees are separate.

What factors make my loan principal go down faster?

Making additional payments toward the principal balance could make your loan principal go down faster. This kind of payment is called a principal-only payment. 

When you make extra payments on top of your regularly scheduled loan payments and apply them toward the principal balance, your principal balance will decrease. That's because the funds will be applied to the loan principal, not interest, fees, or future loan payments. 

In addition to lowering your loan’s principal, your efforts could save you money. Since interest is calculated as a percentage of the principal balance, reducing your loan principal balance could lower the amount of interest you pay throughout the life of the loan. 

Here’s an example: Paying off our $100 loan in 8 months by making extra $5 payments brought the total interest charge down from $6.62 to $4.32. Imagine this loan with a lot of zeroes at the end and the potential for saving money grows.

As you chip away at your loan’s principal balance, you’ll also get closer to paying off your loan and eliminating your debt—which could be a major win for your personal finances. 

How to reduce your loan principal balance faster

Want to pay down your principal balance faster? Make extra payments toward the loan principal. 

Most lenders allow you to make extra loan payments. However, applying additional payments to the principal isn’t always automatic. Some lenders apply extra payments toward interest and other fees unless you specify otherwise. 

Before making an extra loan payment, ask the lender to confirm that it will be applied to the principal balance. 

How often should you make additional payments toward the principal? Some people make extra loan payments regularly, such as bi-weekly or monthly, while others make occasional extra payments when their budget allows. Choose whichever strategy works best for your finances. Every extra principal-only payment helps to reduce your debt. 

Pro tip: Some lenders charge a fee for paying back your loan early. It’s called a prepayment penalty, and you’d want to ask about it before you accelerate your payoff. Achieve never charges a prepayment penalty.

Following a budget may help you afford to make extra loan payments. The Achieve MoLO money app is a free budgeting tool that makes it easy to track your spending and budgeting progress.

Speaking the language of loan

There aren’t five loan languages. There’s just one. And once you know the concepts, it’s a lot easier to understand how to manage your money. Knowledge is power. Now that you've taken this first step to understanding the basics of loans, you're equipped to make smarter choices and navigate your financial journey with more confidence.

What’s next? 

• Make a list of all of your loans. 

• Log into your lenders’ payment portals to get the details for each loan, including the principal balance. 

• Track your principal to make sure that it goes down every month, and if your payments are paused, do your best to pay the interest charges each month. 

• Pay as much as you can toward the principal if you want to reduce your total interest charges or pay off your loan early.