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Principal on a loan is the original amount you agreed to pay back. Over time, the principal balance goes down as you make payments. But because of the interest you also pay on a loan, only a portion of your recurring payments goes toward paying down the principal.
The principal balance helps determine how much interest you owe with each of your monthly payments, so paying down your principal can help you save money on interest charges.
Principal vs. Interest
The principal balance of your loan is the original amount you borrowed, while the interest is what you pay for the privilege of borrowing the money. With most loans, your monthly payment is split up between principal and interest.
Only in rare cases where a lender isn't charging interest—such as with a 0% intro APR credit card—will the full payment amount go toward the principal balance on a loan. There are also types of loans that put your payments exclusively toward interest for a period of time; interest-only mortgages are an example of this.
Interest is generally expressed as an annual percentage rate (APR), which is applied to your principal balance each month. When you make your payment, the lender typically applies it first to the outstanding interest, then the remainder goes toward paying down the principal.
As you pay down the balance, the interest rate is applied to a lower principal amount each month, which results in less of your payment going toward interest charges and more of it going toward the principal. This process is called amortization.
For example, if you have a $200,000 mortgage loan with a 30-year term and a 3.5% interest rate, your monthly principal-and-interest payment will be $898.09. To determine how much of your payment will go toward interest in a given month, you'll divide 3.5% by 12, then multiply that number by the remaining balance.
For your first payment, $583.33 will go toward interest and $314.76 will go toward principal. But five years down the road, $523.23 will go toward interest and $374.86 will go toward principal.
Because mortgage loans have long repayment terms, paying down the principal is a slow process. But let's say you have a $30,000 auto loan with a 60-month term, a 4% interest rate and a $552.50 monthly payment.
With your first payment, about $100 will go toward interest and the rest will go toward principal. But in three years, only $42 will go toward interest.
How to Pay Off Your Principal Balance
Paying down the principal balance on a loan reduces how much you owe and also how much you pay in interest. As a result, paying down principal faster than your scheduled payment plan can save you both time and money.
In addition to your minimum monthly payment, which includes interest, lenders allow you to make extra payments. If you make the extra payment at the same time as your regular monthly payment, all of it will go toward the principal balance. But if you make the extra payment at a different time, a portion of it may go toward the interest that has accrued since your last payment.
Keep in mind, though, that some lenders may charge prepayment penalties if you pay off a loan early. This type of fee is most common among mortgage lenders, but it can also occur with other loan types. Read the fine print on your loan agreement to make sure you don't get slapped with a fee for paying off your loan early.
Improve Your Credit to Save More on Interest
Making extra payments is one way to save on overall interest charges, but you could potentially get even more savings by qualifying for a lower interest rate.
Interest rates are influenced by a number of factors, but a major one is your credit score. Before you apply for a loan, check your credit score to see where it stands. If your score needs some work, review your credit report to get an idea of which areas you can address to improve it.
Depending on your situation, getting caught up on late payments, paying down credit card balances and ensuring all the information on your credit report is correct can help increase your credit score. Then, when you apply for the loan, you may be able to secure a lower rate.
The process of improving credit can take time, so it might not be a good solution for short-term borrowing needs. But if you plan to borrow again in the future, now is a good time to start laying the foundation for a strong credit history to help you save money when you need it.