Principal Vs. Interest: What’s the Difference?
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.
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.
The principal balance is the amount of the loaned money that the borrower still owes, excluding interest.
The interest payment on a loan is the amount of each payment that goes towards the interest. These payments are typically made in installments.
The principal payment is the amount of each payment that goes towards the principal balance.
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 month = 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 quicker. 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 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 their 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.
With an understanding of the relevant concepts, you can come up with a strategy for paying off your loans. If you have more disposable funds that you can put towards your loans, paying off as much as possible quickly will save you a huge amount in interest payments. Otherwise, you can refinance and consolidate your loans for a better interest rate and a single monthly payment.