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.

Breaking down a loan: principal vs interest

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. 

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).

Interest rate 

Interest rates are annual figures, even though most lenders calculate interest every day or month. 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 less than $7 in interest.

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

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.

This is why some financial experts advise borrowers to take a 15-year mortgage instead of a 30-year mortgage. 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 instance, 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.

What factors can make my loan principal go down faster?

A great way to make your principal go down faster (and get rid of the debt sooner) is to make additional payments toward your principal on top of the regularly scheduled payments. The cool thing about making additional payments is that any amount helps. 

Most lenders allow you to make extra payments. The lender will first apply the extra money to unpaid late fees or other charges. Once those are in the clear, some lenders will automatically apply the extra payment to your principal, and that would lower your total interest expense and help you pay off the debt ahead of schedule.

Applying extra payments to the principal isn’t automatic, though. Some lenders apply the extra money to future payments, and that doesn’t help you save money. Before you make an extra payment, confirm with your lender that it’ll be applied to your principal balance. The goal of extra payments is to owe less, pay less in interest, and pay off the debt sooner.

Paying off our $100 loan in 8 months by making extra $5 payments brings the total interest charge down to less than $4.50.

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.

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.