What is the principal of a loan? Definition and examples

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?

Put simply, the loan principal is how much you borrow with the loan. Your principal balance is how much of your principal you still need to repay. The principal doesn’t include any other charges like interest or if you owe late fees. 

Loan principal can apply to any loan type, whether you’re talking about a personal loan, mortgage, business loan, etc. It’s one of the most basic parts of a loan. 

Your loan principal is important because it lets you track how much you still owe of what you borrowed. Lenders also use your principal balance to calculate your interest charges each month; as your principal decreases, so should your interest fees. 

Principal vs. interest: what’s the difference?

Most monthly loans are amortized, meaning your monthly loan payment is split into the principal portion and the interest portion. These two portions represent very different parts of the loan.

• Principal is the money you borrowed. The principal balance is how much you have left to pay on your loan. Over time, as you make payments, your loan principal gets smaller until you’ve paid off the loan completely. 

• Interest is what your lender charges you to borrow that money. The lender calculates your interest payment each month based on your principal balance and interest rate. The higher your balance, the more you’ll pay in interest. 

How loan payments reduce principal

Your loan principal and interest are intertwined, even if you don’t always know it. If you have a fixed-rate loan (the most common type of personal loan), your monthly payment stays the same until you pay it off. 

Behind the scenes, your monthly payment is actually divided up into two parts: principal and interest. This is called amortization. You can typically see how your payments will be divided by looking at the amortization schedule for the loan.

Every month, your lender recalculates how much of your monthly payment goes toward interest. They calculate your interest based on your interest rate and loan principal: the larger your principal balance—when you’re just getting started repaying the loan—the more interest you pay. So your first payments will go mostly toward interest, with the rest going to pay down your principal. 

As you pay down the loan, your principal balance gets smaller and smaller. When that happens, you’ll start to notice the interest portion of your monthly payments get smaller, too. That leaves more money to go toward paying down your loan principal. By the time you’re getting close to paying off the loan, most of your monthly payment will actually be going toward paying down the principal—not the interest. 

It’s fun and refreshing to watch your loan balance going down so quickly toward the end, even though you’re making the same payment. 

Why principal matters: cost, interest, payoff time

Your loan principal is important for lots of reasons:

• Collateral. This is something of value you own that backs up a loan. Some lenders only let you borrow a large principal amount for a secured debt, like a home equity loan. This allows the lender to foreclose on your home if you don’t repay the large debt. 

• Payoff time. Larger loans take longer to pay off than smaller loans.

• Qualification. You’ll often need better credit and a higher income in order to borrow a larger amount.

• Financing costs. You’ll generally pay more interest on a larger loan than a smaller loan. 

Knowing how loan principal works also gives you more power to control it. For example, if you can afford to make extra loan payments early on, you can shrink your principal balance faster. That way, you’ll pay less in interest and get rid of debt sooner. A win-win. 

Principal balance vs. original principal

Sometimes people are confused by a loan’s principal balance and the original principal, but it’s simple to understand. Let’s break it down.

The term original principal means the principal balance when you first take out a loan. You might also see it written as: original loan amount, original balance, starting balance, or something similar. It’s how much you borrowed at the start, in other words. It’s handy to keep track of this number so you can see how far you’ve come in your payoff journey.  

Your principal balance is how much of your principal you still owe. You might also find this written as outstanding loan balance or current loan amount. If you’ve been paying down your loan for a while, your principal balance will be smaller than your original principal. 

For example: Let’s say you first borrowed $5,000, but you’ve paid it down to $2,500. In that case, $5,000 is your original principal, and $2,500 is your principal balance.