What is a Principal Payment?
Summary
A principal payment is a payment that goes toward the original amount that you borrowed but not interest or fees. Learn how it works and how it affects your loan.
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When you take out a loan, the amount you borrow is called the principal. However, that’s not all you owe. You also have to pay interest (the cost of borrowing money), fees and, depending on the type of loan, extras like escrow, insurance or taxes. With every payment you make on a loan, only part of your payment goes toward the principal — the rest goes toward the additional costs of the loan. The part that goes toward your principal is your principal payment.
In some cases, you may be able to make something called a principal-only payment which is an extra payment that goes entirely toward your principal. You might consider making additional principal payments if you want to reduce your debt or pay off your loan faster — if your budget can handle the additional expense.
Learn more about principal payments, how principal-only payments work and how to know whether your loan is eligible.
How do principal payments work?
To understand how principal payments work, it helps to first understand how loans and interest work. Let’s say you take out a $10,000 personal loan with a repayment term of three years. The loan has an interest rate of 18%.
The $10,000 is the principal amount, but if you pay off your loan according to the schedule, you might pay an additional $3,014.86 in interest and fees.
Most installment loans (like personal loans) are amortized which means the balance is divided into fixed, regular payments that cover both the principal and interest. Even if your payment amount is always the same, the portion that goes to your principal and the portion that goes to interest may change over time. At the beginning of a loan term, most of your payments could go to interest. By the end of the loan term, most of your payment could go toward the principal.
Depending on the type of loan you have and your lender’s policies, you may also be able to make principal-only payments to reduce your debt, pay down your loan more quickly and potentially save on interest — as long as the extra payments fit into your budget.
How do principal-only payments work?
You can typically make principal-only payments on certain types of installment loans. With an installment loan, you borrow one lump sum up of money up front and then repay it in fixed payments with interest. Personal loans, student loans and traditional mortgages are all examples of installment loans.
Whether you can make principal-only payments on your loan depends on how your lender charges interest. When you take out a loan, your lender may charge either precomputed interest or daily simple interest.
- Precomputed interest is calculated up front and added to your balance on day one.
- Daily simple interest adds up (or accrues) every day on the current amount of the unpaid balance until the loan is repaid.
You can make principal-only payments if you’re being charged daily simple interest but not precomputed interest. Your lender also needs to allow principal-only payments — not all lenders do.
How to make a principal-only payment
To make a principal-only payment, first check with your lender to make sure they allow them. If principal-only payments are allowed, follow your lender’s instructions. For example, you may have to make the principal-only payment separately instead of adding it to your regular payment so the lender knows what to do with it. Simply sending your lender more money than usual doesn’t guarantee that the extra payment will go toward your principal.
Benefits of making additional principal payments
Paying more toward your principal could help in several ways:
Potentially save money on interest
Interest is charged based on the principal amount still owed. For a daily simple interest loan, the less of the principal balance you owe, the less interest you may pay. That’s why making extra principal payments can save you on interest over time. This may come in handy for larger, longer-term loans such as auto loans or mortgages. Even increasing principal payments by a small amount could help you save a lot on interest in the long run.
Reduce debt
Since the principal begins as the amount of money you borrowed, making extra principal payments may help you pay the loan off faster. However, if you want to pay off your loan early, be careful about prepayment penalties. Some lenders charge an extra fee to recoup lost interest if you decide to pay off the loan ahead of schedule.1 (OneMain Financial doesn’t charge prepayment penalties on its loans.)
Build equity faster
Making extra principal payments on a home or auto loan can help you build more equity by reducing the amount that you owe to your lender. Equity is the current market value of your home or car minus how much you owe on your loan. You can think of it as the portion of your home or car that you own. Building more equity means you will keep more money if you sell the asset. It could also be helpful if you want to refinance your home or open a home equity line of credit (HELOC) in the future.
Potentially improve your credit score
Paying off an installment loan early could help your credit score by reducing the amount of money that you owe to creditors. Depending on the credit scoring model, lowering your “amounts owed” might boost your credit score.2
Paying off a loan early may also have a few small negative effects on your credit score such as reducing the mix of credit that you have and reducing the length of your credit history. But these typically don’t count as much as the amounts owed factor.3
Tips for paying down your principal faster
Here are some ways you could set aside a little more for your principal-only payments:
- Round up your monthly payment: Rounding up your payments can be a simple way to put a little more toward your debt each month. For instance, if your payment is $455, you should aim for $460. If you can, aim for the nearest $50 or $100. Just remember that you may need to make principal-only payments separately or specify that the additional amount paid is for the principal only. Follow your lender’s instructions.
- Put windfalls toward your debt: You could also use any onetime money that comes your way such as a tax refund, bonus or gift to put toward paying down the principal.
- Budget with a focus on repayment goals: Look at your budget and see what changes you can make to help you pay down your principal balance more quickly, whether that means reducing your nonessential spending, adjusting your savings goals or reallocating your funds some other way. Whatever method you choose, making the conscious effort to build additional principal payments into your budget can help you stay on track.
Take control of your loan repayment
Knowing how principal payments work makes it easier to plan for payoff. If your lender allows it, making an additional principal payment on your loan could help you reduce your debt more quickly.
Sources
1 https://www.consumerfinance.gov/ask-cfpb/what-is-a-prepayment-penalty-en-1957/
2 https://www.myfico.com/credit-education/credit-scores/amount-of-debt
3 https://www.experian.com/blogs/ask-experian/credit-education/score-basics/what-affects-your-credit-scores/
This article is for general education and informational purposes, without any express or implied warranty of any kind, including warranties of accuracy, completeness, or fitness for any purpose and is not intended to be and does not constitute financial, legal, tax, or any other advice. Parties (other than sponsored partners of OneMain Financial (OMF)) referenced in the article are not sponsors of, do not endorse, and are not otherwise affiliated with OMF.
