How Do Principal and Interest Work?

What Are Principal and Interest for a Loan?

Principal is the amount you borrow and interest is the added charge you pay to borrow it. The interest rate determines the total cost of a loan and how long it will take to pay off the principal.

Mature couple discussing loan principal and interest in their living room.

The decision to borrow money isn’t one that most people take lightly. If you’re thinking about taking out a loan to achieve a financial goal, two terms you’ll want to understand are principal and interest.

These two loan elements work together to determine how much it will actually cost to pay back what you borrow.

What is principal?

The principal is the original amount of money lent to a borrower. For example, if you take out a $350,000 mortgage to buy a house, the principal is $350,000. However, that’s not the total amount you’ll have to pay back. To account for the true cost of borrowing that money, you have to add in the interest.

What is interest?

Interest is the amount a lender charges you to borrow its money. Charging interest is one of the main ways that lenders make a profit. The amount of interest charged depends on the specific agreement between the lender and the borrower, but interest is usually calculated as a percentage of the loan balance, to be paid over a predetermined amount of time. This percentage is called an interest rate.

Interest rates can be fixed or variable, and interest is often paid in installments as part of your regular loan payments, such as monthly or biweekly.

How do principal and interest work together?

When you take out a loan, you need to consider that you are responsible for paying back the principal plus the interest you agree on. That means your loan will cost you more in total than you originally borrowed. The way your loan’s principal and interest work together can vary based on the type of loan, so be sure to read the fine print to understand how often interest is compounded and how much of each payment will go towards the principal.

While you may look at your monthly payments and assume that you are steadily paying off the principal, the fact is that in the early stages of many loan types, most of your money is going towards the interest. That’s because these loans, such as many mortgages, use “blended payments” that include both principal and interest calculated over an agreed-upon amortization period, or the full time it will take to repay the loan (sometimes this is called “amortized interest”). You pay the same amount for each payment, but over time, the principal amount decreases and, in turn, so does the amount of interest charged on it. In other words, the further along you are in paying back your loan, the more of each payment goes towards paying off the principal.

» MORE: How mortgage interest works

How to calculate principal and interest

When paying off a fixed debt like a loan, you are typically paying off a portion of principal and interest with every payment. However, the amount of principal and interest that makes up each payment depends on the way your interest is calculated: as amortized interest or simple interest.

You could do this calculation by hand, but many financial institutions offer online principal and interest payment calculators that will do the math for you. Simply enter the numbers from your loan agreement or the loan you’re considering, including the principal, interest rate, payment frequency and repayment period.

If you’re already paying back a loan, your lender may also include a breakdown of how much of each payment went toward principal and interest on your monthly statement.

Calculators you can try

MORTGAGE PAYMENT CALCULATOR

CREDIT CARD INTEREST CALCULATOR

PERSONAL LOAN CALCULATOR

How to pay off loan principal faster

While interest is a part of almost every loan, the fact is that it adds up quickly and can make your total cost much more than the amount you actually borrowed — especially when you have a high rate. This is one reason why it’s so important to compare interest rates before deciding which loan product or lender is right for you.

While it depends on the type of loan and the terms, some lenders will let you pay off your principal faster than you originally planned to. In Canada, this prepayment option is common with personal loans. It’s also often available for mortgages (though usually with restrictions, and fees if you violate them).

Ask your lender about the prepayment rules that apply to your loan. For example, the lender may allow you to pay extra on top of your regular payments or make a lump-sum payment toward the principal, should you have extra cash on hand. These options may or may not be allowed depending on your contract, so make sure to check with your lender first or you may face prepayment penalties.

Lenders may also allow accelerated weekly or biweekly mortgage payments, which add up to the equivalent of one extra monthly payment each year. These payments still go toward both principal and interest, but since they’re more frequent, they allow you to chip away at your mortgage principal, helping you pay off the loan faster and therefore save on the overall amount of interest.

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