Loans to consumers and businesses have two major components. The amount you borrow is your principal. Your lender also charges interest on the amount you borrow. The payments you make go toward reducing these two amounts, and the lender uses a formula to proportion each of your payments. Then the lender applies this calculation to reduce the total that you owe on the principal and to collect a specific amount of interest. As the original loan balance decreases, the amount you pay in interest each month also decreases.
Common Principal Payments
For mortgages and cars, a lender divides your original loan amount into a set number of payments, based on the length of the loan. The amount that you owe each month on your the loan is fixed for the life of the loan. However, as your loan ages, the proportion of each payment that goes to principal or interest shifts. For instance, if your monthly payment is $100, one month $60 of that payment might go towards interest while only $40 goes towards paying down the principal. But, the next month, $59 could go towards interest while $41 goes to principal. This is because the amount of each payment that goes towards interest is calculated based on the amount of outstanding principal. As the principal is reduced, so is the amount of your payment that goes towards interest.
Interest Payments on Loans
All loan agreements and credit accounts have a specific interest rate that you agree to allow the lender to add to your loan amount. Mortgages often have an annual interest rate, which the lender applies to your monthly payment. Credit cards, student loans and other short-term loans such as car payments also have specific interest rates that determine how much interest the law allows a lender to charge on your original loan and the remaining balance each month. Many consumer loans and credit cards also have variable interest clauses. The lender can automatically increase your interest rate (and your monthly payment) in specific circumstances such as late payments and unapproved high balances.
Principal Reduction Strategies
The life of a loan's principal and interest payments might last much longer than you want them to. Generally, for most people it's easier to reduce the loan principal by sending extra payments or by increasing the monthly payment to more than the lender's required minimum. Both strategies result in fewer or smaller payments due on the principal balance. The borrower needs to specify that funds in excess of the monthly payment are to be applied to the principal balance. Once the lender accepts the additional or larger payment, the decreased principal also results in a lower amount of interest due because of the decreased principal. For many loans, it also decreases the length of the loan.
Principal Payment Fine Print
If you get a windfall such as an inheritance, salary bonus or a large income-tax refund, applying some of your windfall to a loan can help you reduce your principal. However, some loans have prepayment penalties or fees. For large or long-term loans, you must talk to your lender before sending an unusual amount of money as a credit against your principal. Of course, you might have the right to pay off the entire principal, but a chat with your lender will clarify your actual principal balance and any fees that apply to prepayment.