What Is a Loan Principal?
When you take out a small business loan, your payments are separated into principal and interest. Understanding the differences between these two portions of your loan will help you make the best financial decisions for your business—and it could save you money in the long run.
Here we’ll explain loan principal in simple terms, and help you understand the pros and cons of paying off your loan principal faster.
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What is a loan principal?
A loan principal is the total amount you borrow when you take out a loan. This amount will decrease as you make payments toward your loan. For example if you take out a small business loan for $50,000, your loan principal will initially be $50,000. This number will decrease with each monthly payment.
Loan principal vs. interest
While loan principal is the total amount of money you’ve borrowed, interest is the price you pay to borrow that money. Most lenders base interest off a percentage of the principal. For example, you might get a $50,000 small business loan with a fixed 6% interest rate. This rate applies to the remaining principal each time you make a payment.
The lower your interest rate, the less you’ll end up paying over the total course of the loan. You can get a better interest rate by having a good credit history.
How does loan principal work?
Once the money has been borrowed, you can slowly pay back your loan principal with monthly payments. When you first begin making these payments, most of the money will go toward interest, with only a small portion going toward the loan principal. This is because loan interest typically gets paid off first—and the greater your loan principal, the higher your interest will be.
Your minimum monthly payment will stay the same throughout the life of your loan. But over time, a larger portion of your monthly payment will go toward your loan principal and less will go toward interest, which will then bring down your principal and lower your interest.
Some lenders allow you to pay your loan principal faster, reducing your interest, by making principal-only payments—meaning all of your monthly payment goes toward your loan principal rather than a portion going toward interest.
What happens if you pay your loan principal faster?
Whether you’re making multiple loan payments throughout the month, making additional principal-only payments or contributing a lump sum, there are several ways to pay your loan principal faster.
Doing so will result in fewer payments, a shorter term, and greater savings over the life of your loan. And since interest is based on your loan principal, paying down the principal quickly will reduce the total cost of interest over your loan term.
In the long run, paying off your loan principal quickly can help you reduce expenses and increase cash flow for other business expenses. It can also free up your money to handle other debts or simply give you peace of mind, lessening the financial burden of your loan.
But keep in mind—paying your loan principal faster will reduce your cash flow in the short term, requiring you to put more money toward loan payments until the loan is paid off. For business owners who need cash on hand, paying off loan principal faster may not be the best solution
Loan principal is the initial total amount you borrow when taking out a small business loan. The greater your loan principal, the higher your interest will be—and interest will decrease as you pay off your principal. Paying your loan principal faster can help you reduce overall expenses and manage other debts in the long term, but it will also restrict your monthly cash flow until the loan is paid off. If you have the funds to pay off the principal right away, that’s usually the best option. But if your cash flow is limited, you will want to opt for a longer term loan, which will mean paying more in the long run so you can pay less monthly.
Would you like to learn more about small business loans? Check out Business.org for Small Business Loan Terms You Need to Know.
Loan Principal FAQ
What does the principal of a loan mean?
The principal of a loan is the initial amount borrowed before considering interest. For example, if you take out a $30,000 small business loan, the principal is $30,000. If you make $10,000 in principal-only payments on the loan (remember, this doesn’t include interest yet), your remaining principal is $20,000.
Is it better to pay the principal or interest on a loan?
Typically, a lender will apply part of your loan payment toward interest and fees before applying some of it toward the principal. However, you can reduce your principal more quickly by making additional principal-only payments. Since interest is based on the amount of principal, making these extra payments will reduce your interest and overall debt.
What is the principal amount of a loan?
The principal amount of a loan is the original amount of money you borrowed, before considering interest or fees. Most of the time, a lender will apply your payment toward interest and fees before reducing the principal of the loan.
What happens when you pay off the principal on a loan?
Paying off the principal of a loan will reduce the total amount of the loan you’re required to pay interest on, allowing you to reduce your total debt and pay off the loan more quickly.
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