Loan payments, in general, primarily consist of principal and interest.
The loan principal is the amount of money you borrow to cover an expense. Interest, often a percentage of the principal balance, is the cost of borrowing the capital. Interest is how lenders make money from loans.
We’ll dive into how the loan principal affects what you pay in interest and how you can lower the principal amount with targeted principal payments.
What Is the Principal Balance?
The loan principal is the total balance of money involved in a specific transaction. Let’s review loan principal versus bond principle:
The loan principal is the total amount of money paid out to the borrower. This refers to the original amount of funding borrowed as well as the current balance.
For example, if you graduated from college and incurred $100,000 in student debt, that total is considered the original loan principal. After you’ve paid off half of that total, the remaining $50,000 — aside from any accrued interest — is considered your principal balance.
A bond’s principal — also referred to as par or face value — is the amount listed on the bond itself. It’s the amount of money the issuer owes to the bondholder upon maturity. It doesn’t include the interest — or coupon — that accrues over the bond’s life. When the maturity date is reached, the face value plus any accumulated money is paid out by the issuer.
For example, a standard par value is $1,000. With a term of 1 year and a 5% coupon rate, you can expect to be paid $1,050 — your bond principal plus $50 in accrued money.
How Does Loan Principal Affect Business Taxes?
While the loan principal balance remaining on your loan can’t be deducted from your small business taxes, interest is another story.
Interest, however, is a different story. As it does with personal home and student loans, the Internal Revenue Service will take into account what you pay and will consider it on your taxes.
Calculating Interest From Principal
Your business loan’s interest rate will be higher or lower based on your business and personal credit scores, as well as other risk factors.
The percentage rate you get based on your creditworthiness determines what number to use to calculate your interest payments. These calculations are then applied to your principal balance to add to your monthly installment.
The formula will be different depending on the type of financing you’re seeking, what it will be used for and who the lender is.
If you were financing a car for your business for $25,000 at an interest rate of 5% over 5 years, this is what you would pay in interest.
Principal x Rate x Term = Total Interest
$25,000 x 5% x 5 years = $3,306
Over the life of the car loan, you would pay $6,250 to the lender on top of the $25,000 purchase price, or $31,250.
Factor rates are commonly used in small business financing. Factor rates express the total cost of borrowing a specific amount as part of a business loan and are calculated once at the beginning of the lending period.
This means they’re set in stone at signing and will have to be repaid no matter what. Whether you pay off the balance in 3 or 6 months, the amount you pay in interest won’t change.
Factor rates are easy to calculate. For example, let’s apply the formula to a $10,000 merchant cash advance used to finance day-to-day operations.
Principal x Factor Rate = Repayment Amount
$10,000 x 1.2 Factor Rate = $12,000
Repayment Amount – Principal = Total Cost of Borrowing
$12,000 – $10,000 = $2,000
When signing for this type of funding, you agree to pay back .2 times the loan principal amount, or 20% in finance fees.
In amortized loans, your interest is calculated on the amount of the original balance you have left after every payment. The calculation itself is similar to the example above, but it is dependent on the most recent ending balance. Although your payments are fixed, the interest-to-principal ratio changes as the loan matures.
How Loan Principal Is Paid
There are multiple approaches to paying the principal of a loan. What you’re using the funding for and your creditworthiness affect the type of repayment structure you’re given. Understanding them and how you can manipulate your principal loan balance will help you pay less and put more money back into your small business.
Common in car and home loans, amortized payments are based on an amortization schedule. In these agreements, you have an equal payment each month that consists of both principal and interest, which is calculated off your current balance.
This payment structure is interest front-loaded, meaning the majority of your payment goes toward interest at the beginning of the term. As the interest portion of an amortized loan decreases, the loan principal portion of the payment increases.
If your 30-year mortgage for $200,000 has a 4% interest rate, your monthly payment will be $954.83. Of that amount, your first installment would only pay down $288.16 of the original $200,000 balance. After 360 months, however, you’ll pay $143,738 in interest.
These types of loan structures take the guesswork out of repayment. Your principal payment is fixed, but your interest charge changes, meaning instead of having an ever-changing ratio, the original balance is paid out equally for each installment. However, like their amortized counterparts, even-principal payments have you paying more interest in the beginning of your repayment schedule than you will as the loan matures.
Therefore, your remittance payment will be higher at the beginning of your term and lower as your loan matures. For example, you take out a $10,000 loan with 10% interest over a 10-month term. In month 1, you pay $2,000 ($1,000 of which comes off of the original balance and $1,000 toward interest). In month 10, your payment is $1,100, with $100 going toward interest.
Sometimes referred to as bridge loans, the repayment structure consists of interest-only payments. They’re very short-term — usually about 6 months — and are for small business owners who need money fast and can’t afford a high monthly payment.
The entire principal loan balance — a large sum referred to as a balloon payment — is due at the end of the term. You’ll have to either cough up the money or, more commonly, refinance into a more palatable loan.
Paying Down Your Principal Faster
Unless your lender uses factor rates, you can considerably cut down your repayment costs by lowering your principal on a loan. Because interest is calculated off your current balance, putting more money into it allows less money to accrue. There are a couple of ways to do this, but either will save you money in the long run.
First, you can add extra money into your payments earmarked for the original principal loan balance. For example, if you tack an extra $100 onto your $954.83 mortgage payment each month and pay $1,054.83, you’ll eventually save more than $25,000 in interest and about 5 years of payments on your $200,000 mortgage.
You also can make targeted, principal-only payments throughout the loan. Some homeowners will use a portion of their tax return to pay down their mortgage balance, for example. Spending a little extra now in a loan principal payment will always save you more in both dollars and time in the future.