What is a Principal Payment?
A principal payment is a payment towards the total principal amount owed. In other words, a principal payment is a payment made on a loan that reduces the amount due in the future. In accounting and finance, a principal payment applies to any payment that reduces the amount due on a loan.
Bond Principals are further analyzed on CFI’s Fixed Income Fundamentals Course.
The Basics of a Loan
Understanding the components of a loan is very important. Every loan comprises two components – the principal and the interest. The principal is the amount borrowed while the interest is the fee paid to borrow the money.
Consider an individual who saved $400,000 to pay for a $1,000,000 home. The individual would need to borrow $600,000 from the bank to complete the transaction. The $600,000 is the principal amount – the money borrowed. The bank may require a 5% annual interest on the principal amount – the fee paid to borrow the principal amount.
The individual in the situation above would need to make an annual total payment that consists of principal and interest payments. The principal payment goes to reducing the outstanding principal amount due while the interest payment goes to paying the fee to borrow the money.
There are generally two types of loan repayment schedules:
- Even principal payments
- Even total payments
Even Principal Payments
In an even principal payment loan, the principal payment amount is the same every period. Consider John, who takes a $10,000 loan with a 10% annual interest over 10 annual payments. The loan repayment schedule would look as follows:
In the loan repayment schedule above, the loan amortizes over 10 years with even principal payments of $1,000. In 10 years, the unpaid balance would be $0.
The principal payment each year goes to reducing the unpaid balance. Since the principal payment each year is $1,000, the unpaid balance would be reduced by $1,000 yearly. The interest payment is calculated on the unpaid balance. For example, end of year one interest payment would be $10,000 x 10% = $1,000.
Even Total Payments
In an even total payment loan, the total payment amount is the same every period. Consider John, who takes a $10,000 loan with a 10% annual interest over 10 annual payments. The loan repayment schedule would look as follows:
In the loan repayment schedule above, the loan amortizes over 10 years with even total payments of $1,627.45. In 10 years, the unpaid balance would be $0.
As opposed to an even principal payment schedule, the principal payment increases yearly. It is due to much of the initial total payment going towards paying back interest than principal. In the first year, the amount of interest would be $10,000 x 10% = $1,000. With a total payment of $1627.45, the unpaid balance is only reduced by $1627.45 – $1,000 = $627.45. In such a schedule, interest payments decrease, and principal payments increase over time.
Even Principal Payments vs. Even Total Payments
Over the amortization of the loan, the total payment in an even principal payment schedule is $15,500 while the total payment in an even total payment schedule is $16,274.54. It indicates that by repaying a higher principal amount each year, an individual would save money over the amortization of the loan.
A higher principal payment on a loan reduces the amount of interest owed and, in turn, reduces the total amount paid over the life of the loan. Therefore, principal payments play a significant role in the amount an individual must pay over the lifetime of a loan.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: