At SmartCapitalMind, we're committed to delivering accurate, trustworthy information. Our expert-authored content is rigorously fact-checked and sourced from credible authorities. Discover how we uphold the highest standards in providing you with reliable knowledge.
A principal balance is, at its most basic, the amount outstanding on a loan that needs to be repaid to satisfy the debt. It does not take into account future interest or fees that will accrue. The principal balance is equal to the full amount of money initially borrowed minus what has already been paid against it, without adding in any of the interest that needs to be paid.
It is best to illustrate this concept with an example. If one takes out a mortgage for $100,000 US Dollars (USD) at six percent interest, the initial principal balance is $100,000 USD. Each month, the borrower will make a payment to the mortgage lender. A large portion of the payment will go to pay the accrued interest, while the rest of the payment will begin to pay down the principal balance. As the months go on, the amount of the payment will remain the same, but a larger portion will go to pay the principal.
The loan is paid off when all of the principal has been paid. This process of making interest/principal payments is referred to as amortization, and is common for mortgages and car loans. Interest on the loan is charged on the amount of the principal balance. Each month, the borrower will typically receive a statement that includes information on the principal balance remaining, though one can easily determine that by looking at an amortization schedule online. To pay off a loan in full, it is necessary to call the lender and request a payoff amount of the principal balance along with any added interest or fees.
In a loan with compound interest, the amount of interest that accrues each month is added, or compounded, to the amount of the principal. This means that the principal amount will actually go up, and the interest will be calculated based on that new, higher amount. When applying for a loan, be sure to read all of the documentation carefully. Compound interest is common on credit cards.
One simple way to pay off a loan early is to make a larger payment than is due. Check with the lender, but in most cases, the extra amount in the payment will automatically be applied to the principal. For example, if the amount owed one month is $300 USD, and the amount paid is $350 USD, that extra $50 USD will be applied directly to the principal to decrease the overall amount owed on the loan. Some loans may feature prepayment penalties, so once again, be sure to read all loan documentation carefully.