Principal
To build and protect financial well-being everyone should know fundamental concepts like simple and compound interest, APR, principal, etc. Because of that in the current article, we give a definition and a little more information about a critical component like the principal in the context of loans.
Learn what the loan principal is, its relationship with interest, and some concepts of loan principal repayment.
What is principal?
The loan principal indicates the amount borrowed by the customer by the lending institution.
What is the relation between Interest and Principal?
The principal is the actual borrowed amount, while the interest is the cost of borrowing.
The principal is the base on which the interest rate is calculated. The larger the principal, the higher the interest payments. That is logical since the interest rate is determined as a percentage of the principal or based on the percentage of the principal plus the previously accumulated interest.
For example, if the loan is $ 10,000 and the annual interest is 5%, the interest for the year will be $500 assuming there are no payments toward the principal.
About the principal Repayment
The monthly payments of the loan typically are divided between interest and principal. At the beginning of the loan term, the larger part of every payment goes toward the interest. With time, as the principal decreases, the proportions change and the larger portion goes to the principal.
To repay the principal in advance a customer should make extra payments beyond the required monthly amount. The additional payments have to go directly toward principal reduction.
The benefits of Principal Prepayment
Interest savings
One of the best benefits of principal repayment is that it can save money from interest over time. Since interest is calculated on the principal balance, reducing that balance early on means that less interest will accrue over time.
Shorter Loan term
By reducing the principal more quickly, the customer can pay off debt faster than planned.
Improved Financial Security
Removing debt can bring a piece of mind and build the fundaments of greater financial security.
Drawbacks and Considerations
However, despite the benefits, there are some potential drawbacks to consider.
Prepayment penalties
Some loans could have prepayment penalties which can be pricey. These additional fees are designed to compensate the lender. Before principal repayment, it is important to check the loan agreement.
Emergency or opportunity costs
While paying off the debt is a great financial move, it is important to be in sync with the current financial situation and the potential of the repaid money. Sometimes that money can provide security by ensuring an emergency fund or could be made as an investment that could bring a good return.