A principal payment is a payment toward the principal or original amount borrowed. Mortgage payments consist of two components which include principal and interest. It is important to understand the components that contribute to mortgage payments.
As a real estate teacher, I’ve noticed that most students get confused when understanding principal. If you’re one of those students, I’ve got you covered.
In this post, I’ll define the principle and explain it with the help of examples.
What Is a Principal Payment?
A principal payment is a payment towards the original amount of the loan that a borrower takes.
Loan repayment consists of two components: interest and principal. The principal payment is a component of the repayment structure that reduces the principal amount in the mortgage.
Principal payments apply to all types of loans, including business loans and auto loans. In all loans, the principal remains the same throughout the term while the interest adjusts accordingly. The total monthly payment on a regular mortgage is calculated as follows:
Total monthly payment = Principal + Interest + Escrow + Mortgage insurance
In the equation above, the total monthly payment includes the principal, interest, escrow (taxes), and mortgage insurance. Payments towards the principal reduce the principal balance, but it doesn’t affect the interest amount.
How Does Principal Payment Work?
The principal payment reduces the portion of the principal on the loan. For example, if a person borrowed $150,000 from a bank. The $150,000 is the principal amount or the money borrowed. The lender will require repayments from the person, which include principal and interest. The principal payment on this loan will reduce the principal amount due. The interest payment will reduce the interest amount, which is the fee the lender charges to lend the money.
Payments towards the principal result in quick repayment of the loan, and it decreases the loan balance. The principal payment remains the same throughout the term, while the interest may or may not change. When the interest rate is fixed, the monthly payment is fixed too. However, when the interest rate varies, the monthly payment also changes, but the principal still remains the same.
The following are the cases in which the monthly payments can change:
Mortgages can be fixed-rate or adjustable-rate mortgages. With adjustable-rate mortgages, the interest rate is fixed for a few initial years. Once this introductory period is over, the rate increases according to a pre-agreed percentage. When the interest rate changes, the total monthly payments also change. If the interest rate increases, the monthly payments increase, and vice versa.
Extra Principal Payments
A few lenders allow borrowers to pay more toward their principal balance. The borrowers can make lump sums or increase their monthly payments towards the principal. In this case, the principal payment changes throughout the term. Making extra payments towards the principal reduces the loan balance. When the remaining loan balance decreases, the interest amount also decreases.
Refinancing a mortgage means when the borrower replaces their existing mortgage with a new one. The new mortgage has different rates and terms which change the monthly payments. Refinancing is a financing technique in which a borrower wants more favorable rates and terms with a new mortgage.
Principal vs. Interest Payment
When someone takes a mortgage for a certain amount, it’s not only the repayment that they must make. The lender levies a fee in exchange for offering the loan, called interest.
Interest Payment and Balance
Interest is the cost of borrowing money. When a person borrows money, they have to pay interest on the loan amount. Lenders charge different interest rates from the borrowers depending on various factors. The interest payment is a component of the monthly payment that goes towards the interest charges. Interest is calculated as a percentage of the interest amount.
For example, if the interest is 4%, the interest amount is calculated by applying this rate to the loan. Interest rates can be fixed or variable. If a person takes a loan of $15,000, they’ll have to pay a monthly amount to the lender. This payment will include principal and interest.
The monthly interest payments will be calculated by applying the interest rate to the loan balance. If the interest rate is 4%, the interest payments will be $15,000 X 0.04 = $600. This is the annual interest rate; to obtain monthly payments, you can divide the annual payment by 12. The monthly interest payment will be $50 in this case.
Principal Payment and Balance
The principal balance is the balance that the borrower still owes apart from the interest. Each principal payment will reduce the principal balance. In the above example, $15,000 is the principal the person obtains as a loan. The borrower has to pay this principal amount in the form of monthly payments to the lender.
Types of Principal Payment Schedules
There are two types of principal payment schedules, which are as follows:
Even Principal Payments
Even principal payments are those in which the principal payments are of the same amount for every payment. These principal payments are calculated simply by dividing the loan amount by the number of installments. Each month the due loan amount reduces, and the interest payment is calculated on the unpaid balance.
Even Total Payments
Even total payments are those principal payments that increase yearly. These are loans in which more interest payments go towards interest payments. Thus, the principal payment is low at the start, increasing gradually. On the other hand, the interest payment is high at the start and decreases as the loan matures.
Principal Payment Example
Example 1: Suppose John takes a mortgage of $150,000 to purchase a house. The lender offers a 6% interest rate, and the term is 10 years. The following is the breakdown of the principal payment on this mortgage:
- Mortgage amount: $150,000
- Interest: 6%
- Term: 10 years
- Principal payment: $915.31 per month
- Interest payment: $750 per month
- Total monthly payment: $1,665.31
John has to pay $1,665.31 monthly on this mortgage to the lender. This payment includes a $915.31 principal payment and a $750 interest payment.
Example 2: Suppose a company XYZ has to purchase an office to carry out its business operations. To do so, the company applied for a loan of $300,000 to purchase a property. A bank decided to give a loan of $300,000 with a 6% interest rate over 6 annual payments.
|Year End||Starting Amount||Repayment||Interest Component||Principal Component||Amount Outstanding|
The company XYZ has to pay principal payments of $40,000 annually throughout the term. However, the interest payment changes as the outstanding amount (due balance) decreases. The total repayment includes the interest and the principal payments. The due balance reduces till the loan matures at the end of the six years.
Frequently Asked Questions
What are the Benefits of Principal Payment?
One of the major benefits of principal payments is that it reduces the debt on a loan. By making principal payments, the borrower increases their equity. Besides that, if the borrower makes early payments, it also saves interest for the period. Principal payment helps companies to maintain a healthy balance sheet by reducing their debts.
What are the Drawbacks of Principal Payment?
In some cases, financial institutions charge a notional fee from the lender when they make principal payments.
What to Know for the Real Estate Exam
The principal is the amount that someone borrows to purchase a home. The principal payment is one of the components of the payment that the borrower makes to the lender.
It’s important as real estate professionals to understand the difference between principal and interest. Interest is the amount that the borrower has to pay as a cost of the loan. It is the amount the borrower must pay to the lender for taking a loan from them. The interest rate determines the amount of interest the borrower has to pay as interest. As the borrower makes more payments towards the principal, they gain more equity in their property.
I hope that now you completely understand the definition of principal. If you want to learn more about real estate terms, go through this Real Estate Vocabulary.