If you have ever applied for a small business — or car, student or home — loan, you may be familiar with what principal means. If not, you might wonder who the person in charge of your business loan is and if they will put you into detention if you go into default.
Fear not, as there is a simple answer to what business loan principal is, how it affects what you pay in interest and how you can drive it down with targeted payments.
What Is Principal?
By definition, business principal can refer to the owner or another person in charge. On the financial side, however, it refers to the total balance of money involved in a specific transaction. Three types of basic transactions deal with it.
The principal of a small business loan is the total amount paid out to the borrower to cover their specified business expense. This can refer to the original amount of funding you had borrowed, but also the balance at any specific point in time.
For example, say you graduated from college and incurred $100,000 in student debt. That total is considered the original loan principal. In a few years, after you have paid off half of that total, your remaining balance is $50,000, plus any accrued interest. Fifty-thousand is then considered your principal balance.
Unlike a loan, the principal of an investment is static. Simply put, it refers to the original amount of money that was invested.
For example, say you want to take some of your personal funds and invest $10,000 into a promising startup. A year down the road, that money has doubled to be worth $20,000. When you start being paid dividends, you’ll refer to that original total as your “principal investment.”
A bond’s principal—also referred to as “par” or “face value”—is the amount listed on the bond itself. In other words, it’s the amount of money the issuer owes to the bondholder upon maturity. It does not 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 one 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 Interest?
Small business loans, like any other, are made up of two parts: principal and interest. It’s important to learn a bit about the relationship between these two to help you understand how they affect your monthly payments and, therefore, your bottom line.
Interest is what you pay a lender over the life of your loan. It’s what gives them the ability to make money off of the transaction. Your rates will be higher or lower based on your business and personal credit scores, as well as other risk factors.
Calculating Interest From Principal
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’ll be used for and who the lender is.
As the name suggests, it’s easy to calculate simple interest. It’s straightforward, taking the numbers and applying them directly to each other to come up with a total. Take the following example as if you were financing a car for your business for $25,000.
Principal x Rate x Term = Total Interest
$25,000 x 5% x 5 yrs = $6,250
Over the life of the car loan, you would pay $6,250 to the lender on top of the $25,000 purchase price.
Factor rates are commonly used in small business loans. According to Kris Direnzo, Sales Team Lead at Fast Capital 360, 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 that they’re set in stone at signing and will have to be repaid no matter what. In other words, if you pay off the balance in 3 months or 6, the amount you pay in interest will not change.
Factor Rates are, however, similarly easy to calculate. For example, let’s apply the formula to a $10,000 merchant cash advance you take out to finance your small business’s 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 principal amount, or 20 percent in interest.
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 above example but is dependent on the most recent ending balance. Though your payments are fixed, the interest-to-principal ratio changes as the loan matures, but we’ll get into that later when we talk about repayment.
This type of interest is not as common in small business lending, but you need to know about it if you’re applying for a business credit card. It can be confusing but, simply put, it’s calculated by applying the negotiated rate to your current balance at any point in time, including unpaid interest. Fees compound on a monthly, quarterly or yearly frequency.
Let’s look at a quick example of how this works. Say you charge $1,000 on your small business credit card. Your APR is 24 percent (2 percent monthly). At the close of your first billing period, your new balance is $1,020 (1,000 X 2 percent). If you pay a quarter of this total ($255), your new balance is $765. Interest will now accrue on this new total. Your balance is, therefore, $780.30 (765 X 2 percent) in your next payment cycle.
Luckily, you rarely see this model used in a small business loan contract.
How Principal Is Paid in Loan Agreements
Like variations in interest, there are multiple ways to pay off loan principal. What you’re using the funding for and your creditworthiness have a lot to do with the type of repayment structure you’re given. Understanding them all and how you can manipulate your balance can 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 of what your current balance is.
This payment structure is interest “front-loaded.” This means the majority of your payment goes toward it at the beginning of the term. As that portion of an amortized loan decreases, the principal portion of the payment increases.
For example, your 30-year mortgage for $200,000 has a 4% interest rate. Using an amortization calculator, you know that 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 only pay $3.17 in interest.
These type of loan structures take the guesswork out of repayment. Instead of having an ever-changing ratio, the original balance is paid out equally for each installment. They do, however, share one trait with their amortized counterparts: you’ll pay more interest in the beginning than you do as the loan matures.
In other words, your principal payment is fixed, but your interest charge changes. 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 percent 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 only $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. Typical examples are emergency equipment financing or buying popular commercial real estate.
At the end of these terms, the principal will be the same as it was at signing. You’ll be stuck with a “balloon payment” and will have to either cough up the money or, more commonly, refinance into a more palatable loan.
Unless your lender uses factor rates, you can cut your repayment costs down considerably by lowering your principal balance. Since interest is calculated off of 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 balance. Take our mortgage example from earlier. If you tack an extra $100 on each month and pay $1054.83, you’ll start to cover enough to save over $25,000 in interest and about 5 years of payments.
You can also 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 will always save you more in both dollars and time in the future.
How Does Loan Principal Affect Business Taxes?
You might be wondering if having outstanding loan balances can be used to lower your small business’s tax burden. Well, in short, it doesn’t. Unfortunately, any principal you have left on your loan can’t be deducted.
Interest, however, is a different story. Like it does with personal home and student loans, the IRS will take into account what you pay and will consider it on your taxes. As always, get together with an accountant or take the time to do your research to make sure you’re on top of your small business’s taxes.
Reviewing Loan Principal
Hopefully, you’re now an expert when it comes to understanding financial principal. You’ve learned the role it plays in home, student, car and business loans, investments and bonds. Also, you now know how it’s used to calculate interest, and how the two work hand-in-hand as you pay back your lenders.
Make sure to keep up with your loan provider and use targeted payments to lessen your financial obligations down the road. If you’re currently looking for a loan and wanted to learn more about what they’re made up of, contact one of our business advisors to get everything you need to fund your small business.