taking notes on a book about loans

Loan Principal Explained

The loan principal is the amount you borrowed in the loan. This is different from the loan interest, which is the cost of borrowing the principal amount.

A loan principal is the original amount of money borrowed via a loan. The loan will generate interest, and this will be added to the original amount. This is the basic way interest and loan repayment works, allowing borrowers to get the money they need and lenders to make a profit on the loans they offer. You might come across this term when getting a home mortgage, a personal loan, student loans, or setting up your 401K.

Loan Principal or Loan Principle?

The first thing we should get out of the way is the difference between the words principal vs principle. Both of these words sound the same and have very similar spellings, but they have very different meanings. Luckily, their different meanings should make it a little easier to differentiate between the two of them. 

The word principle refers to a rule, moral, belief, or truth. For example, you might use the word principle when talking about something you believe in, or something you believe to be right or good. 

“Stealing the toy went against Jimmy’s principles.”

The word principal has 2 different definitions. The first definition of principal refers to a person’s job or station, like the principal of a school. One way to remember this definition is that the word principal has the word “pal” at the end of it, and the principal of the school is a pal to the students. 

“The principal addressed all of the students in the assembly hall.”

The second definition of the word principal comes from its use in the world of finance. In finance, this word refers to the initial amount, or the original amount, of a loan or mortgage. For example, you might take out a loan for $500 and end up paying $550 total when adding interest and fees. But the principal balance of this loan would still be $500. 

“The loan principal was $500 before interest.”

Loan Principal Definition

So when you are referring to the loan principal, you want to use the word “principal” and not the word “principle.” But this word can refer to many things in the financial world, not just the initial loan balance. 

In lending, loan principal refers to the original sum of money you borrowed from the bank, mortgage lender, or other lenders. 

In investing, this term can refer to the original sum of money you put into an investment or the original value of an investment or asset. In a 401K retirement plan, the principal amount might be the original amount you put in savings toward your future retirement. 

In business, this term can be used to refer to the primary owners or stakeholders in a company. It could also refer to the main parties involved in a major transaction. 

Loan Principal Payment Definition

The principal payment on a loan is any payment that is going directly toward the original sum of money borrowed, rather than going toward the added interest. Amortization is the calculations that help figure out how your payments go toward the initial amount borrowed and the additional cost of interest. 

You can think of a loan as having 2 parts: the loan principal and the loan interest. 

The loan principal is the amount you borrow and the loan interest is the amount you pay the lender for borrowing that money. When your loan is set up, each payment will be set up to pay back the original amount borrowed and the extra interest. These principal payments and interest payments could be set up as even principal payments or as even total payments

Even Principal Payments

In this repayment plan, each payment is divided between the principal and the interest, and the amount that goes toward the initial loan amount is always the same. For example, you might pay $50 toward the principal loan amount each month, while the amount you pay toward the interest each month varies. 

This then results in uneven total payments. The perk to using this repayment plan is that your regular payments gradually go down throughout the life of the loan. 

Even Principal Payment Example:

For example, if your first payment is $100 then your next payment might be $75, and then $50, and so on. 

Even Total Payments

In this repayment plan, each payment is divided between the principal and the interest, and the total payment each month is always the same amount. For example, if your regular payments are $50 then they will be $50 for each pay period throughout the life of the loan. 

This then results in even total payments and uneven payments toward the principal balance and the interest. The perk to this repayment plan is that your total payment is always the same, making it easier to work into your monthly budget. 

Even Total Payment Example: 

For example, you might have a total payment of $50 with $30 going toward the original loan amount and $20 going toward the interest. 

The Difference Between Principal and Interest

Principal and interest are both the main categories that make up your loan and loan payments. But they aren’t the same thing. In simple terms, you can think of principal as the amount you borrowed and you can think of interest as the amount you pay the lender. 

It’s important to understand the distinction so that you fully understand how much you are paying for your loan and how your monthly payments work. Each payment will go toward paying off the loan principal and the loan interest. The process of calculating these payments is called the amortization schedule. The principal is also going to be a lump sum of money while the interest is going to be a percentage rate of that lump sum, also known as an APR or Annual Percentage Rate. 

In Conclusion, 

Taking out a mortgage is a huge financial decision. Personal loans can be much smaller than a home mortgage, but understanding how the different parts of the loan work together is still important to understand what you’re paying. In a 401K plan, this concept can be essential to understanding how your retirement savings grow.