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What Is a Loan Principal. If you are planning on taking out a loan, you may have noticed that the actual amount you borrow is different from the loan payments you make.
That is because the actual amount that you borrow in a loan is called the loan principal. Whereas the additional charges to that loan principal are the additional fees and interest that you have to pay.
In this comprehensive guide, we will explain what a loan principal is, how it works, whether paying more principal would reduce your monthly payments, and how your loan principal impacts a loan.
So read on.
What Is a Loan Principal?
The word “principal” has several meanings in the world of business and finance. It means the original sum of money that is invested in a financial product or lent in a loan. This term signifies the actual account that is invested or borrowed when you take a loan from a financial institution.
The loan principal is applicable to all kinds of loans, whether it’s a business loan, a car loan, a mortgage, or a credit card balance. It signifies the exact amount that is borrowed, which is then added to the fees, interest charges, and any other additional charges charged by the lender.
When you repay a certain loan amount, a part of this repayment is split to pay off the loan principal amount, whereas the remaining amount is used to pay off the interest charges and other fees.
So what is the difference between loan principal and interest? Let’s find out! What Is a Loan Principal.
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Loan Principal vs. Loan Interest
When taking out a loan, it is important to know how much you will be repaying. This repayment amount includes both your loan principal and interest. But how do these two differ?
Well, your loan principal is the actual sum of money that you borrowed from a financial institution. Whereas the interest is the cost of borrowing that loan. This additional cost is charged by banks, financial institutions, or credit unions to leave them with a profit. It is a percentage of your loan principal.
Loan Principal vs. Loan Balance
You may also often come across the term “loan balance” during your loan term. Your loan balance is also impacted by your loan principal.
So what is the difference between loan principal and loan balance? Well, your loan principal is the actual amount of money you borrow from a lender. Whereas the loan balance is the amount remaining from your loan principal after making a loan payment.
It is the outstanding amount of money you owe to your lender, this includes your loan principal, as well as any additional charges and fees.
How Does Loan Principal Work?
To explain how loan principal works, let’s take a look at an example. Suppose you have taken out a loan of $5,000 for a year. You have paid $1,000 in down payment, so your loan principal is now $4,000. The annual interest rate charged by your bank on your loan is 4% and you make monthly payments of $400.
Now the first month’s interest payment will be calculated as follows:
Loan principal x Interest rate / Loan term
$4,000 x 4% / 12 = $13.33
This is the total monthly amount you will have to repay. $13.33 from your $400 monthly payment will be paid as your monthly interest, whereas the remaining $386.67 will be reduced from your loan principal.
How Does Loan Principal Impact My Loans?
The loan principal determines the amount of interest you pay on a loan. When repaying a loan, the repayment amount is first used to cover the interest charges and other fees. Only then is the remaining amount then used to pay the loan principal.
You can reduce your interest amount by paying down the loan principal. As you continue to make payments on your loan, your loan principal will decrease, until it reaches 0. That’s when your loan term ends as you have repaid your entire loan amount.
Does Paying More Principal Reduce Monthly Payments?
Now that you know how the loan principal works and impacts your loan, you need to understand whether it can be repaid faster. Well, there is a way you can repay your loan principal faster.
By making additional principal-only payments, you can reduce your overall loan principal. However, this would not reduce the interest charged on your loan.
So your interest amount for each month will remain the same, but your loan principal will be lesser. This way, you can easily repay your loan principal with fewer monthly installments.
How Does Loan Principal Affect Taxes?
For individual taxpayers, it may be possible to subtract the loan interest amount they pay each year. For instance, student loan interest payments and mortgage interest may be deductible from your taxes. However, the payments you make towards your loan principal balance are not deductible.
In the case of business loans, the loan principal is only a percentage of the amount you pay to buy a business asset. The total amount, also known as the cost basis, includes all the initial costs, down payment, and the costs to purchase an asset.
You can spread this cost out over the asset’s lifetime to get business tax deductions for that period. You can also write off interest expenses that are paid every year. However, there are some limitations.
Conclusion
What is a loan principal? The loan principal is the actual amount you lend from a lender. It is different from loan interest, which includes the interest and other charges charged by your lender. It is also different from loan balance, which is the outstanding amount you owe to your lender.
So that’s everything you need to know about loan principal and how it impacts your loans. We hope you find this guide helpful. Good luck!
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