What Is Loan Principal and Why Is It Important?
Are you considering a business loan? Or your small business loan was already approved? If yes, you might notice that the amount you will pay off includes additional factors.
When borrowing money from lenders, the amount you need to repay is calculated as follows:
- The amount borrowed
- The interest charges
- The additional fees incurred
These figures are added to the overall repayment as well as to the loan principal. In other words, you have to make payments to reduce the loan principal to $0 throughout your loan’s entire timeline. This is why anyone must know and understand what loan principal is and its role in the overall repayment.
What is Loan Principal?
Loan principal refers to the amount of money you borrow from a lender when taking out a business loan. It includes the amount borrowed and includes fees, interest charges, and additional charges.
For instance, if you have a $40,000 loan to purchase a piece of new office equipment, $40,000 is your initial loan principal. Since the loan balance comprises the principal and interest charges, expect that interest may increase the balance despite having a $40,000 initial loan principal loan.
Once you reduce the loan balance amount, your principal also reduces. After repaying the original amount, you will be left with a $0 principal.
How Does It Work?
To understand how loan principal works, let’s take a quick example.
Suppose you take a $40,000 loan, and the lender charges you a 6% annual interest rate. Once you receive the loan and make the first payment, the loan principal remains $40,000.
On the other hand, you need to pay a $200 interest, $40,000 (loan principal) x 6% (interest charged) / 12 (term). If your monthly payment is $800, then the $600 will take care of the principal, and the remaining $200 will go toward the interest.
After making the first payment, the loan principal goes down to $39,400. This keeps decreasing until your loan principal reaches $0.
What is the Difference Between Loan Principal and Interest?
Interest is an important factor in determining the amount to be paid off when calculating a loan. However, the loan principal is also crucial to help understand how much amount you should pay back.
The loan principal is the amount borrowed, while the interest is the cost attached to that money. Business lenders, credit unions, or any banks include interest as it helps them make a profit.
Here, your loan principal is a fixed amount or number, while the interest is the percentage. Please note that the amount of interest you owe depends on your business credit history and the unique policies of the lender.
In most cases, your interest rate can be lower if you have a stronger credit history and a higher credit score. There, it is necessary to build good credit before taking out a business loan.
What is the Difference Between Loan Principal and Loan Balance?
Besides the interest, the loan balance is another essential component for loan repayment. It is also affected by the loan principal.
The loan principal is used as the base for interest and add-on charges. So, $40,00 was the original amount borrowed, and once you make the first repayment, your actual loan balance is the reduced loan principal you need to pay off.
The total loan balance usually consists of the loan principal plus the additional charges that might incur over time. So, the loan principal differs from the loan balance for most financial loans, which can be higher because of fees, penalties, interest, and other inclusions.
Different Types of Principal Payments
The loan principal is critical as it is the amount that you have to repay. It is the basis for calculating the interest, so understanding how it impacts your overall loan agreement is essential.
Below are the different ways you can repay your principal:
- Even-Principal Payments
With these payments, your monthly payments remain the same. However, the amount that goes toward the interest and principal changes over time. While you are paying off the interest, more of the monthly payment goes toward repaying the principal.
- Amortized Payments
If you choose this process, you need to use fixed payments to spread out the loan. Although the payment amount remains the same every month, the funds go toward the loan’s different parts. When you pay off more of the loan principal, for example, you will be left with less interest to pay later on.
- Principal Payment
Through this payment, you only need to pay off the principal. So you do not have to pay any interest. This helps lower the interest’s overall accrual.
- Interest-Only Loans
Choosing this method allows you to only pay the interest for your loan term’s first few years. After the initial period, expect the interest rate to change. Then, you need to start paying off the principal.
How to Determine the Loan Principal
You can check your loan’s monthly statement, which mentions the breakdown of the amount you owe to the lender and the amount to be paid to identify your loan principal. Additionally, since each amount is deducted from the principal balance, you can better understand your progress with every loan repayment.
If the statements of documents do not reflect your loan principal, you can contact your lender. Keep in mind that the lender is responsible for providing the borrowers with detailed information regarding the loan repayment, interest rate, loan principal, add-on charges, and other costs added to the loan payment.
Why Paying Your Loan Principal Faster is Advantageous?
Most lenders allow borrowers to repay their loan principal faster. This flexibility lets you make additional payments, including principal-only payments, to help reduce the principal. So, if you have an extra amount to repay your loan faster, do it because a lot of benefits are waiting for you, like:
Savings on Monthly Payments
If you make additional payments on your loan principal, it helps reduce the overall monthly installment for your loan’s entire duration. It is because the interest is calculated based on the remaining loan balance. As a result, your extra payment will save you a lot of money in the long run.
Lower Payment Term
One way to shorten your loan term is by making additional payments on your loan principal. For instance, if you have a 2-year loan term and make extra or multiple additional payments, you do not have to pay an amount after your principal amount reaches $0.
Gain the Much-Needed Peace of Mind
People with any loan or debt usually experience stress. On the other hand, making additional payments help bring down the amount of the principal. In return, you can make the repayment process a lot easier.
If you cannot make the entire payment for a month, the late fees or additional charges incurred are often much less. This is because they are levied on your loan principal for that month. So paying off your loan principal as soon as possible gives you much-needed peace of mind.
Most lenders and financial institutions allow principal-only add-on payments, but you still need to consider your credit score and other terms and conditions. So, if you avail of any financial loan, make sure to determine the faster repayment options and know whether your lender accepts principal-only payments.
Does Loan Principal Impact Taxes?
The loan principal plays a critical role in taxes. Knowing this is vital, particularly if you apply for a business loan.
In most cases, loan principal helps get tax deductions and save money. If you are an independent taxpayer, your loan principal can be tax-deductible, depending on the loan or financial instrument you availed.
For instance, for student loans or mortgage interest, the payments toward the principal balance can be tax-deductible. But please note that the loan principal will only be tax-deductible, not the interest.
For business, your business loan’s principal amount can also be claimed for tax deductions. It will consist of the amount you paid, including any down payment, initial costs, or costs to buy an asset.
Whether it is a personal or small business loan, it is critical to fully understand all components involved, like interest, principal loan, and additional charges. Also, comparing the financial options that lenders offer is recommended to make sure you obtain the most financially viable and safest deal. Do not forget to read the fine print before signing any document. This helps save you thousands of dollars throughout the loan term.