Understanding finance terms can sometimes feel like trying to learn an entirely new language. When I first started educating myself on how credit and debt worked, I had to constantly check glossaries and online dictionaries to make sure I understood the difference between various balance types, interest rates, or types of fees that come up.
In just about any credit document, you’ve probably seen the term “principal balance.” But just what does it mean?
The principal balance is the original amount of a debt, without any interest or finance charges assessed.
If you take out a student loan for $10,000, your principal balance is that initial $10,000. If you charge $500 on your credit card, the principal balance is that $500 charge. Of course, it’s not always that simple. Certain choices you make or agreements you have with your creditor can increase the principal even after you’ve begun paying your debt.
To understand how your principal affects the terms of your repayment and, ultimately, your financial life, you’ll need to know all the nuances.
How Loan Principal Works
How a principal works depends a lot on the type of loan you have. Different loans treat the initial balance of your debt in different ways, including the possibility of adding unpaid interest into the principal each month. Know your loan type, and you’ll know what to expect.
Personal Loans
For personal loans, there are two types of principal you’re likely to encounter: initial principal and outstanding principal.
Your initial principal is the amount of money you borrow. For example, a personal loan of $500 has an initial principal of $500. Your outstanding principal is the amount of money you continue to owe after making payments. For example, if you made three payments of $75 each on your loan, your outstanding principal would be around $275.
Personal loan payments allocate part of your payment to the principal balance, and part of your payment to finance charges. In general, your initial principal is divided over the course of the payment term as equally as possible — for example, $500 over 12 months comes out to about $41.67 per month of your principal. The rest of your monthly payment goes to finance charges.
Unpaid finance charges or late payments may be rolled into your principal balance as part of your outstanding principal. If you have an especially high interest rate, this can cause a rather stressful chain reaction, resulting in you paying significantly more money over time.
The good news is that any payments made in addition to your monthly payment go to chipping away at the outstanding principal, so if you can pay a little extra here and there, your overall interest charges will be lower.
Auto Loans
Auto loans are often amortized like mortgages, with a similar allocation of the monthly payments. Part of your fixed monthly payment goes to the principal, and part goes to your interest, and over time the allocation of interest to the principal shifts more and more in favor of the principal.
Another aspect of auto loans to keep in mind is that the interest on these loans is simple interest, not compound interest. I’ll explain more of the fine details on that later, but auto loans typically require a flat percentage of the total each month, as opposed to a growing amount over the course of the loan.
A key thing to be wary of when it comes to auto loans is that cars are a depreciating asset. The car you buy today will lose, on average, 10% of its value as soon as you drive it off the lot, and 50% of its value within 10 years.
Your loan principal and interest rate are based on the value of your car when you buy it, not while you’re driving it.
This can have some rather stressful implications for borrowers who take out a loan for an expensive new vehicle, only to find themselves underwater as the value of the car decreases, but their payments stay the same.
Mortgages
Just as with personal loans, your mortgage principal is the initial amount that you borrowed. Unlike personal loans, most mortgage payment agreements are amortized. Amortization is kind of a complicated concept in finance, but for mortgages the important thing to remember is that it means you’re paying less of your principal up front, and more toward the end of your mortgage term.
Mortgage amortization means that you pay a consistent amount per month for the life of your loan, with more of your payment allocated to interest initially, and more to the principal later on.
Another aspect of mortgage payments to keep in mind is the fact that the amount of your payment that goes to your principal each month increases the equity you have in your home. Equity is another loaded finance term that can mean different things depending on the context, but for home loans, it’s the amount you would receive if your house was sold.
Because most home loans are amortized, paying off your principal works a little differently compared to other loans. In addition to your monthly payments, you can pay a lump sum specifically to the principal, or just submit an additional payment that will be distributed to both your principal and interest.
If you get a check on your birthday or some other kind of windfall money, using it to pay down your principal can help you reduce your monthly payments and interest.
How Principal Impacts Interest
In any loan, your interest rate reflects not just your credit history and rating but also the amount you’re borrowing. Different loans and loan terms can impact the amount of interest you pay over time, so it’s important to know what you’re looking at in your loan agreement and to understand your terms fully.
Fixed vs. Variable Interest Rates
Two of the most common terms you’ll see to describe interest rates are fixed and variable. A fixed interest rate means that you pay the same rate for the life of the loan, regardless of any outside variables.
Variable interest rates fluctuate over time, based on a set standard. Either one can be a good option, depending on your circumstances and other factors.
Fixed-rate interest plans are typically higher than the starting percentage of a variable-rate loan. In addition, your principal plays a major role in determining your rate: a larger principal balance means a larger fixed rate, and a longer payment period.
Variable interest rates are less dependent on the principal balance, but larger balances go along with either a larger starting rate or a bigger spread of potential interest rates over time.
Another wrinkle for borrowers is the fact that while you might come out ahead if the index rate goes down, you might also find yourself underwater if the index rate goes up.
Compound Interest and Principal
Compound interest is a tricky idea to wrap your head around and usually requires getting out the calculator to understand what’s going on. In loans, compound interest is usually calculated based on a daily running balance, multiplied by a daily fraction of the annual interest rate.
For savings and investment accounts, compound interest is still complicated, but can play in your favor in many ways. The calculations are similar, but instead of increasing your debt, the compound interest increases your saved balance.
At the end of each compounding period, the interest goes to your principal, which then gives you a larger balance for the interest to compound on.
This means that even a modest savings account with a relatively low interest rate can really help you start accumulating more money.
While it takes time, as long as you leave the money in your savings account untouched, it continues to earn you more and more.
Amortization and Principal
As I mentioned before, amortization mostly affects the allocation of your payments, but it also has an impact in setting your monthly payments and the overall amount of money you pay over the life of a loan.
Your principal plays a major role in setting an amortization schedule because the goal is to gradually increase the amount of your payment that goes to that principal debt, instead of to interest.
If you’re starting with a higher principal balance, your amortization schedule will be longer because the interest on a larger balance will be a larger amount. It will take longer for the payments to chip away at the principal enough to reduce the interest charges.
Your monthly payment is also going to be more substantive because your interest charges will be higher to start.
Keep these factors in mind when you’re deciding on any kind of amortized loan, whether it’s an auto loan or a mortgage. Many people found themselves “underwater” on their home mortgages in the 2008 financial crisis because the value of their homes suddenly plummeted, but they were still on the hook for large loans they took out to purchase the property.
Principal in Credit Cards
Principal balances on credit cards operate a little differently compared to other types of debt because credit cards use a revolving debt system compared to a single instance of debt. But you still have strategies to optimize your credit card usage and get the most benefit while avoiding the worst of interest situations.
Revolving Debt and Principal
Credit cards are what’s called a revolving debt account. This means that you don’t just take out a loan and pay it back. Instead, you’re more or less continually adding and subtracting the debt you carry based on a set maximum credit limit.
Your principal balance on a credit card is the amount of money you charge on the credit card within a certain period. Your principal balance grows and shrinks based on your card usage and payments. So during months that you charge more on your card, your principal grows, and on the months that you pay extra, your principal decreases.
Because your debt fluctuates, your monthly payments typically do as well. Instead of a set amount per month, you’ll usually receive a bill that offers a few different payment options and a period of time (usually 28 days) within which to make your payments.
Minimum Payments and Principal Reduction
Credit card statements generally include a minimum payment due, which is assessed by the creditor as the smallest amount you could pay per month — based on your balance at the time the bill is issued — to pay off the entire balance in a set time. That set period is usually one year, but it can vary from one creditor to another.
Your minimum payment includes your finance charges for the compound interest calculated on your debt for the period the bill covers. In essence, part of your minimum payment is the total amount of interest your debt generated over the course of the statement period. The other part of your minimum payment is a small portion of your balance.
Minimum payments on credit cards work like monthly loan payments, in that part of your payment goes to the principal and part of the payment goes to the interest.
One very basic way to reduce your balance on your credit cards over time is to make additional payments. Consumer protection laws enacted in the wake of the 2008 financial crisis require credit card companies to apply additional payments to the balance, rather than to interest. A few extra payments reduces your principal, which in turn lowers your monthly interest charges.
How to Manage Your Principal
Managing your principal balance effectively will make an enormous difference when it comes to getting your debt under control. A lower principal means that your interest charges decrease, which over time lowers the amount you pay back. I have two favorite methods for managing my principals to keep my financial life on track.
Accelerate Principal Payments
Making additional payments on your credit accounts helps reduce your principal faster since creditors are required by law to apply supplemental payments to the principal rather than the interest.
If you have extra money at your disposal at the end of the month, or get a financial windfall of some kind, putting all or part of it toward your accounts with the highest interest rates can save you a lot of stress and money.
It’s best to use this particular tool selectively, however. Assess your different credit accounts, and take stock of which balances you can impact in a meaningful way with the money you have at your disposal.
A credit card that has a large balance with a very low interest rate can wait for a longer time. Instead, you should try to pay in full and remove completely from your debts a credit card with a smaller balance and a very high interest rate.
Refinance to Lower Principal
Another tool I’ve successfully used to manage my principal is refinancing.
By refinancing a loan or revolving credit account, you typically lower the interest rate and terms, which results in a lower monthly payment.
However, that change in interest rate can have a strong impact on your principal as well.
For debts with compound interest, or those where unpaid interest rolls back into the principal, lowering your monthly payments gives you more opportunities to make additional payments to chip away at the balance.
It also reduces the amount of interest that rolls into your principal, lowering it over time.
Reducing Your Principal Can Help You Pay Off Debt Faster
Understanding your principal balance is a key step in managing your debt effectively. By reducing your principal through extra payments, consolidations, or other methods, you can lower your monthly payments over time and actually pay less on the loan or credit you take out.
As you pay your debt off faster, your credit will improve, making it easier to seek financing options when you need them. Better credit makes it easier to rent or buy a home, find better employment, and take care of yourself and your family, so managing your principal is a big step toward improving your whole life.