How Do Principal and Interest Work?

What Are Principal and Interest for a Loan?

Principal is the original amount of a loan and interest is the added charge you pay to borrow it. Principal and interest determine the total cost of a loan and how long it will take to pay off.

Mature couple discussing loan principal and interest in their living room.

The decision to borrow money isn’t one that most people take lightly. If you’re thinking about taking out a loan to achieve a financial goal, two terms you’ll want to understand are principal and interest. These two loan elements work together to determine how much it will actually cost to pay back what you borrow.

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What is principal?

The principal is the original amount of money lent to a borrower. For example, take out a $350,000 mortgage to buy a house, the principal is $350,000. However, that’s not the total amount you’ll have to pay back. In order to find the true cost of borrowing that money, you have to add in the interest.

What is interest?

Interest is the amount a lender charges you to borrow its money. Charging interest is one of the main ways that lenders make a profit. The amount of interest charged depends on the specific agreement between the lender and the borrower but, usually, interest is calculated as a percentage of the loan balance, to be paid over a predetermined amount of time.

Interest rates can be fixed or variable, and interest is often paid in monthly installments.

How do principal and interest work together?

When you take out a loan, you need to consider that you aren’t responsible for paying off just the principal, but the interest as well. And in many cases, interest is calculated on the principal balance remaining at the end of every month.

While you may look at your monthly payments and assume that you are steadily paying off the principal, the fact is that in the early stages of many loan types, most of your money is going towards the interest. However, over time, the principal amount will decrease and, in turn, so will your interest. In other words, the further along you are in payments, the less interest you are paying back and the more of your money goes towards paying off the principal.

» MORE: How mortgage interest works

How to calculate principal and interest

When paying off a fixed debt, you are typically paying off a portion of principal and interest with every payment. However, in the beginning, more of each payment goes toward interest than principal. So, how do you keep track of how much is principal and how much is interest?

There is a way to calculate your monthly principal payment, so you can keep track of how much of the loan principal you are paying off over time.

If you really want to do the math yourself, you can follow this equation:

a / {[(1+r)^n]-1]} / [r(1+r)^n] = p

a = total loan amount

r = periodic interest rate

n = total number of payment periods

p = monthly payment

However, there are much less complicated ways to do this. Many financial institutions offer an online principal and interest payment calculator that will do the math for you. Alternatively, your lender may include a breakdown of how much of each payment went toward principal and interest on your monthly statement.

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How to pay off loan principal faster

While interest is a part of any loan, the fact is we would rather pay more against the principal of the loan and less in interest. This is one reason why it’s so important to compare interest rates before deciding which loan product or lender is right for you.

While it depends on the type of loan and the terms, some lenders will let you let you pay off your principal faster than stated in the loan terms. In Canada, this prepayment option is more common with mortgages.

Ask your lender about a prepayment privilege plan. With these plans, the lender may allow you to increase the number of regular payments or make lump-sum payments toward the principal, should you have extra cash on hand. These options may or may not be allowed depending on your contract so make sure to check with your lender first or you may face prepayment penalties.

Lenders may also allow accelerated weekly or biweekly mortgage payments. More frequent payments allow you to put more money toward your mortgage principal than you would with a monthly payment, which helps you to pay off the loan faster and therefore save on interest charges. Bi-weekly payments can add up to the equivalent of one extra monthly payment per year.