What is a Principal Payment?

What is a Principal Payment?

Definition

An amount that is paid towards the principal of a loan is called a principal payment. When you borrow from the bank or a financial institution, every repayment made by you is split into interest and principal. As a result of these payments, your principal outstanding decreases over time.

What does principal payment mean?

The original principal on a loan refers to the amount that you have borrowed. You will be charged interest on this amount. However, as you make principal payments, this amount will get reduced until it is completely repaid.

Usually, the agreement that you enter into with your banker, allows you to repay the principal amount early. But the agreement may stipulate that you would have to pay a penalty for this. Why should the bank penalize you if you are returning the money that you have borrowed before it is due?

The reason is that when the bank advanced money to you, they expected to earn a certain profit from your interest payments. Now, since you will not be paying interest for the full term of the loan, the bank would try to make up the shortfall by levying a penalty.

Example of principal payment

Jeremy Fitter decides to buy a new car. He selects a Ford Fusion that costs $25,030. Jeremy puts up $5,030 as his down payment and borrows the remaining amount from the bank. His loan will be repaid over a period of seven years from June 2018 to May 2025.

Jeremy’s bank tells him that his interest rate is 5% per year and that he will have to pay a monthly installment of $283. In 2018, a total of seven instalments will be payable, with the first falling due in June.

As Jeremy is expecting to receive some money in about a year or 18 months, he asks if he can repay the loan early. The bank informs him that at the end of 2019, the principal outstanding will be $16,067. If he pays this sum, his loan will be completely repaid. Fortunately, the bank does not charge any penalty for early repayment.

Jeremy decides to take the loan and repay it early if he receives the money that he is expecting.

Summary

Principal repayment refers to repaying the original amount that you have borrowed. It is usually repaid over the term of the loan but can be paid off early as well.