Justin Cupler

Contributing Writer at Tally

June 9, 2020

When applying for a loan or credit card, you're often presented with two key numbers: principal and interest.

Understanding principal and interest — and how they work together to build your loan — is critical to making wise financial decisions. Without this understanding, you may end up with a loan that doesn't cover the costs you need it to or one with an interest rate so high it takes many years to pay off, resulting in interest payments that double or even triple the loan amount.

Below, we'll explain how loan principal and interest work, how the lender uses them, how they're related and more. Before we get into those details, let's look at the definitions of principal and interest.

The principal is the initial amount you receive from a lender or the initial balance you charge to your credit card. The interest is the amount of money that the lender charges you in exchange for the loan or credit card given. Interest is usually calculated as a percentage of your principal balance.

When you first take out a loan or charge something to a credit card, the original amount is the principal balance. As you make monthly payments, the principal balance drops. Once the principal balance reaches $0, the loan or credit card is paid in full.

In some cases, particularly with credit cards, the principal balance may reach $0, but the lender or credit card issuer will add the unpaid accrued interest to the account the following month. In this case, the credit card or loan isn’t paid in full until you also pay off that accrued interest.

When you take out a loan or use a credit card, the company lending you the money is generally a for-profit organization. These companies can earn their profit in many ways, but a common tactic is by charging interest.

When dealing with revolving debt, like a credit card, the lender calculates interest daily and adds it to the principal balance. These interest charges then become part of the principal balance, which the lender charges interest on. This creates a compound interest situation.

Despite the complicated compounding interest, as you pay down the principal balance on a credit card or other form of revolving debt, your interest charges and minimum monthly payments decrease.

For example, if you have a $10,000 credit card balance at 19% interest with a 3% minimum payment requirement, your first minimum monthly payment would be $300.

Of that $300 payment, $158.33 would go toward interest and $141.67 would go toward the principal balance.

After a year of making minimum payments, the minimum monthly payment would decrease to $256.42.

Of that $256.42 payment, $135.33 would go toward interest and $121.09 would go toward the principal.

As you can see in the above example, since credit cards base the minimum payment and interest on the unpaid balance, the interest payments and total payments decrease over time. This simultaneous decrease is part of the reason credit card debt takes so long to pay off when making the minimum payment.

Long-term loans with fixed monthly payments, like auto loans and mortgages, work on amortization schedules, which means the interest charges are already calculated for the life of the loan based on the assumption that you make only the minimum monthly payments.

At the beginning of the amortization schedule, you pay more toward interest than you do later in the loan because the principal balance is higher. As you pay down the principal balance, the interest payments become lower, meaning a larger portion of your monthly payments goes toward paying off the principal balance over time.

For example, if you take out a five-year $20,000 auto loan with a 4% interest rate, your fixed monthly payment will be $368.33.

In the first month, $66.67 of your payment will go toward interest, while $301.66 will go toward paying off the principal.

After one year of making payments, $54.38 of your payment will go toward interest, while $313.95 will go toward the principal.

You can visualize this shift from paying more in interest payments to paying more of the principal balance by looking at your loan's monthly amortization schedule. The schedule shows your projected monthly payments over the life of the loan and how much of your total monthly payment goes toward interest versus the principal balance.

Adding to the complexity of interest are the different types of interest rates.

When you apply for a loan or credit card, you're presented with the interest rate, which can be a fixed rate or a variable rate. The difference between fixed rate and variable rate can have a significant impact on your monthly payment and how long it takes to pay off the debt.

A fixed interest rate is most common in long-term loans, like an auto or home loan.

With fixed interest, the interest rate you agree to at the time you sign the loan documents will remain the same for the entire loan term.

For example, if you take out a 30-year fixed-rate mortgage at 4% interest, you pay 4% interest from your first monthly mortgage payment through your 360th payment.

Variable interest rate loans and credit cards come with various names. In the mortgage industry, for example, they're called adjustable-rate mortgages (ARM), while the credit card and loan industries call them variable-rate credit cards and variable-rate loans, respectively.

Variable interest rates can change monthly, weekly, quarterly or even yearly, and the new rate is based on the lender's interest algorithm, which we’ll cover later. In the case of an ARM, they often have set schedules and caps for interest rate adjustments.

For example, a 7/1 ARM will have the same interest rate for the first seven years. After that, the interest rate can change once per year based on the lender's interest algorithm.

There may also be a cap associated with the interest rate changes on an ARM.

For example, if your ARM has a 4-percentage-point cap per year, but the lender's algorithm calculates a 5-percentage-point increase, your interest rate wouldn’t exceed the 4-percentage-point increase cap that year.

Variable interest rates often offer the lowest upfront rate, especially in mortgages, which leads to lower initial monthly payments. The downside is, as the rate adjusts, so does your monthly payment, making them harder to budget for.

When you take out a loan or use a credit card, you may notice there are two percentages, interest rate and APR. These rates are related but not interchangeable.

APR is the interest rate plus any fees charged on the loan or credit card expressed as an annualized percentage.

For example, if you took out a $10,000 loan with a 10% interest rate, a 10-year repayment term and a $1,000 upfront origination fee, your APR would be 12.578%, according to Calculator.net's APR calculator.

If there are no lender fees associated with the loan, the APR and interest rate will be the same.

In most loans, the principal and interest combine to equal your monthly payment. Some loans, however, have extra fees attached to the payment that pushes the loan terms beyond just a simple principal and interest calculation.

A mortgage loan, for example, commonly has payments exceeding principal and interest. Mortgage payments often also include escrow payments to cover other fees associated with owning a home, including property taxes, homeowner's insurance, homeowner's association dues, flood insurance, private mortgage insurance and more.

For example, if you have $2,000 in annual property taxes, $1,000 in annual homeowner's insurance premiums and a $1,000 in annual HOA dues, your mortgage lender may add $333.33 per month ($4,000/12) to your principal and interest payments to cover these annual costs.

Because these fees can change over time, you may also see your loan payment rise and fall to compensate.

Each lender has its own algorithm for calculating interest rates, but most use similar variables to make the calculation.

Lenders are mostly free to set their interest rates as they'd like, but they must consider the competitiveness of their rates. To remain competitive, most lenders set a baseline using the federal funds rate, which is the interest rate the Federal Open Market Committee says commercial banks may charge each other for overnight loans.

From that baseline, each lender is free to determine their prime rate, which is the interest rate they charge for the ideal borrower. The ideal borrower is one with a top-notch credit score, ample income, an ideal debt-to-income ratio and any other variables the bank determines.

From there, the lender will increase the interest rate based on the financial risk the borrower presents. For example, if a borrower has a 650 credit score, they may get a 7% interest rate, while a borrower with a 750 credit score may get a 5.5% rate.

The difference between the federal funds rate and the interest the lender charges is called the margin. In some cases, you can negotiate within this margin to get a better interest rate.

There's more to interest than just rates, though. You must also look at the loan term to determine how much interest you're paying over the life of the loan. The longer you take to pay off the loan, the higher your total interest payments will be, even if the interest rate is lower.

For example, consider a $10,000 loan with an 8% interest rate on a 10-year term. You'd pay $4,559.31 over the life of the loan. If you opted for a $10,000 loan at 10% interest with a five-year repayment term, you'd pay only $2,748.23 in interest fees.

This lower amount of interest paid is because on a shorter-term loan, you have a significantly larger loan payment — $121.33 per month for 10 years versus $212.47 per month for five years — which means more of your monthly payment applies to the principal earlier in your amortization schedule.

This brings us to the next topic, making extra principal payments and how it impacts your interest payments and loan balance.

When you're looking to get out of debt quickly, the best way is to make extra payments on your debt. The more you pay on a loan, the quicker the principal balance reaches $0 and the sooner you're debt-free.

This also saves you money, as the quicker that loan reaches a $0 balance, the less money you waste on interest payments.

For example, if you have a 30-year fixed-rate mortgage for $250,0000 at 4% interest, you'd pay nearly $180,000 in interest over the 30-year loan term.

If you added an extra payment of $200 to your monthly mortgage payment, you'd not only pay off the loan over seven years earlier, you'd pay over $48,000 less in interest payments.

There are various strategies to making extra payments. Some borrowers prefer to keep it simple by paying a set extra amount each month, like in the example above. Some lenders previously charged penalties for borrowers who paid off their loans early. Newer laws limit prepayment penalties, but some lenders can still charge them in certain cases. Make sure to review your loan documents and account for this prepayment penalty when making extra payments.

People with tighter budgets may prefer the biweekly payment strategy, which involves paying half of the monthly loan payment in biweekly installments. This still pays the entire loan payment within each month but results in the borrower making the equivalent of 13 payments per year instead of 12 with no noticeable strain on their budget.

The biweekly payment system has become so popular some lenders offer it as an official payment option.

With a firm grasp of principal, the amount you initially borrow, and interest, the percentage the lender charges you for their lending services, you're ready to review prospective loans and better understand the terms. You can analyze the loan terms and make better borrowing decisions by looking at the interest rate, length of the loan and the loan repayment schedule to know whether a loan has favorable terms or not.

With a more critical eye on the loan terms, you're setting yourself up for a more secure financial future, free of unmanageable debt.