Principal Vs. Interest: What’s the Difference?

Updated on February 15, 2024

At a Glance

  • Interest in a loan is the fee paid to the lender for borrowing money, while principal is the original amount borrowed, excluding interest.
  • Payments towards interest cover the cost of borrowing, while payments towards principal reduce the actual loan amount.
  • Prioritizing paying off the principal is advisable to minimize interest expenses.
  • Refinancing can help consolidate debts, simplify repayment, potentially reduce interest rates, and aid in debt management.

Staying on top of loan payments can be extremely challenging. Many people get overwhelmed by the wealth of new terms and financial concepts they must learn to meet their obligations, and have difficulty keeping up. Paying off debt must be done strategically if you want to minimize the amount you pay, and this requires an understanding of concepts like principal vs. interest.

This article explores the difference between principal and interest in loans and helps you apply these concepts so you can pay off your debt smarter and quicker.

What’s the Difference Between Interest and Principal?

When you take out a loan for a certain amount, your obligation goes beyond simply repaying this amount. Financial institutions levy a fee in exchange for lending the money, called interest. Understanding the difference between paying off the principal of a loan and paying off the interest is vital. Read on for a comprehensive breakdown of the two.

Pricipal vs. Interest

Interest

Interest is a fee paid to the lender for borrowing money, typically based on an Annual Percentage Rate (APR). The APR is a certain percentage of the total principal balance of the loan.

Principal Balance

The principal balance is the amount of the loaned money that the borrower still owes, excluding interest.

Interest Payment vs. Principal Payment

Interest Payment

The interest payment on a loan is the amount of each payment that goes towards the interest. These payments are typically made in installments.

Principal Payment

The principal payment is the amount of each payment that goes toward the principal balance.

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Is It Better to Pay the Interest or Principal First?

When managing loan repayments, the strategy of focusing on principal reduction is often the most financially beneficial approach. By directing payments towards the principal amount of the loan as much as possible, you effectively reduce the total interest that accrues over the life of the loan. Interest is calculated based on the remaining principal balance; therefore, a lower principal results in lower interest charges.

This method contrasts with merely covering the interest charges, which, while keeping the loan in good standing, does little to decrease the overall loan balance. In essence, paying down the principal at an accelerated rate not only shortens the loan term but also leads to substantial savings on interest payments.

However, it’s crucial to understand the specific terms and conditions of your loan agreement. Some loans may have prepayment penalties or specific rules regarding principal-only payments. It’s advisable to review your loan’s terms or consult with your lender to ensure that any extra payments are applied correctly to the principal and to avoid any unintended fees.

Implementing a strategy that minimizes interest payments within the confines of your loan agreement can significantly impact your long-term financial health. For individuals seeking to optimize their loan repayment strategy and potentially refinance for better terms, exploring options through services like Fiona can provide valuable insights and alternatives that cater to individual financial situations, making it easier to manage debt efficiently and effectively.

Interest and Principal Examples

Getting a grasp on these concepts can be difficult, so read some of the examples below for an idea of how principal and interest function in the real world.

Calculating Interest Payments

Knowing how much of your payments go towards interest is an important part of staying on top of your debts, and all you need is the principal balance and interest rate (APR) to find out:

[Principal balance * (APR)] / 12 months = Monthly interest payments.

So, for example, if you have a $10,000 loan at 6% APR, the calculation would look like this:

[10,000 * (.06)] \ 12 = $50.00

That amount, $50, is how much you would have to pay each month just to pay off the interest on a loan. If you paid exactly $50/month, then, the principal balance would remain untouched.

Paying Down Principal Balance

Now that you can calculate how much of your payments go towards interest, you can figure out how to pay off the principal balance faster. The amount of each of your monthly payments that exceed the interest payment goes towards the principal. So, the more you pay off each month, the faster the principal balance diminishes, and the less overall interest you must pay.

Taking the above example, if you owe $50/month in interest and pay off $100 each month total, $50 of that goes towards the principal. This means, if the loan was for $10,000, you would be paying off $600/year towards the principal and $600/year towards interest, and it would take you about 16 and a half years to pay off.

Alternatively, if you paid $150/month, then $100 would go towards the principal balance. In this scenario, you would pay off the debt in just over 8 years. Also, paying the debt off that much quicker would save you 8 years of interest payments, or nearly $5000.

Making Larger Payments

As the above example illustrates, the quicker you pay off the debt, the less overall interest you pay. This makes paying off debts in lump sums one of the smartest moves you can make.

For example, let’s say you have a $10,000 debt with a 6.00% APR and pay off $5000 in the first year in lump sums. Even if you make the same $100/monthly payments indefinitely from that point on, you have cut the total term length of the loan and the total amount of interest you would have paid by more than half.

Multiple Debts Hanging Over Your Head? Consider Refinancing

Interest payments can compound quickly, especially if you have multiple debts. Many people find themselves stuck in a cycle where they are only paying the interest on their loans, leaving the principal untouched. This can leave people stuck in debt indefinitely.

One way borrowers can escape this cycle is with refinancing. Refinancing is when a borrower consolidates all of their loans under a single lender, with a single rate and a single monthly payment. Oftentimes, refinancing obtains lower interest rates for the borrower and simplifies the repayment process. Rather than multiple debts with multiple interest payments each compounding at its own rate, you can plan for one rate. This gives borrowers a clear idea of the amount they are paying towards interest and principal and often helps them get out of debt quicker.

Also, bear in mind that discovering the perfect loan for your situation is hassle-free. Regardless of the loan type you’re seeking, you can quickly find a match. Navigate to Fiona to access a variety of loan options, making your search convenient and straightforward.

Frequently Asked Questions (FAQ)

What is the Difference Between Principal and Interest?

The principal is the original sum of money borrowed in a loan or the amount of money invested. Interest, on the other hand, is the cost of borrowing that money, usually expressed as a percentage of the principal.

How Does Principal Affect a Loan?

The principal amount of a loan is the base amount that you borrow and are required to pay back. The total cost of a loan includes the principal plus the interest charged on that principal.

What is Interest in Terms of a Loan or Investment?

In terms of a loan, interest is the charge for borrowing money, paid to the lender. In investments, interest is the earnings from investing capital, paid by the borrower or issuer of the investment vehicle to the investor.

How is Interest Calculated on a Loan?

Interest on a loan is typically calculated as a percentage of the principal. It can be calculated using simple interest (calculated only on the original principal) or compound interest (calculated on the principal and accumulated interest).

Can the Principal Amount Change Over the Life of a Loan?

Yes, the principal amount can change over the life of a loan. In an amortizing loan, each payment reduces the principal, gradually decreasing it over the loan term.

What is More Important to Pay Off First, Principal or Interest?

In most loan repayment plans, you pay off both principal and interest concurrently. However, paying more towards the principal can reduce the total interest paid over time.

What Are Principal-Only Payments?

Principal-only payments are payments made on a loan that apply only to the principal balance, not to the interest. These payments can reduce the principal faster, potentially lowering the total interest paid.

How Do Principal and Interest Payments Work in a Mortgage?

In a mortgage, a portion of each monthly payment goes towards paying the interest, and the remaining amount reduces the principal. Early in the loan, a larger portion of each payment goes towards interest.

Does Paying Extra on the Principal Affect Future Interest Payments?

Yes, paying extra on the principal reduces the remaining balance, which in turn reduces the amount of interest calculated on that lower balance for future payments.

Is Interest on Loans Tax-Deductible?

Interest on certain types of loans, like some mortgages and student loans, may be tax-deductible, reducing your taxable income. However, this depends on specific tax laws and individual circumstances.

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Frank Gogol

I’m a firm believer that information is the key to financial freedom. On the Stilt Blog, I write about the complex topics — like finance, immigration, and technology — to help immigrants make the most of their lives in the U.S. Our content and brand have been featured in Forbes, TechCrunch, VentureBeat, and more.