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Principal vs. Interest: Know the Difference to Save Money

6.5 MIN READ

Everyone, at some point in their lives, is likely to take out a loan for one reason or another. Living isn’t cheap, and there are infinite demands for money through every path of life. Whether you have just moved to the States to start education, a new career, or to build a better life, your requirements will be costly.  

Taking out and managing loans can be challenging at times. Financial issues can cause anxiety and feelings of isolation and helplessness. With around 300 million people in debt across the USA, you are not alone. 

One of the best steps you can take is to educate yourself on the financial services out there.  

In this article, you can get to grips with the difference between principal vs. interest in regards to loans. Understanding these terms should assist you in managing your money and repayments with some clarity.

Related Article | The Finance Dictionary: Learn the jargon your Finance friends speak!

Principal vs. Interest: What’s the Difference?

Unfortunately, taking out a loan doesn’t come without added costs. American loan companies and banks will add an interest rate to your loan repayment. 

Student loans, mortgages, and credit card repayments are all frequent contributors to debt and credit score in the United States. As a loan, credit card and more are usually quite vital in living a comfortable life, it can be tricky to avoid them, along with the hefty interest they accumulate. 

So, let’s have a look at what the difference is between principle and interest.

Principal Balance

The principal is the amount of money still owed by the borrower, excluding any added charges. 

Interest

Interest is a charge the borrower has to pay for borrowing the money. This amount usually depends on the Annual Percentage Rate (APR), which is a percentage of the principal balance. 

Banks and other money-lending companies are free to choose their interest rates. However, market levels and the Federal Reserve Bank influence rates at the national level. 

The Difference between the Two

You can take out loans that are either principal and interest loans or classified as interest-only loans. Principal-interest means paying off both the original balance and the interest together.  

Interest-only advancing is when you pay just the interest fees over a set period. It is at the end of this period that you will then begin to pay off the amount of money you initially borrowed. 

Related Article | Can I Deduct Student Loan Interest On My Taxes If The Loan Was From A Non-US Bank?

Calculating Your Loan Repayments 

Although the concepts themselves might be quite simple to understand, when put into practice, it can become a bit confusing. To help track your financial burden and status, you can calculate interest payments. 

You can figure out your interest rates for monthly payments, as follows (get out your calculator!): 

[Principal balance x APR] / 12 = your monthly payment for interest

The 12 represents the 12 months of the year. 

So, if you have a loan of $15,000 with an APR of 8% you would work it out like this: 

[15,000 x 0.8] /12 = $100 interest monthly payment

The amount of $100 would cover your interest rate and only that, not any of your principal balance.

Annual Percentage Rate 

Banks and other money lending companies legally have to show customers this rate before they take out a loan amount. You must make sure you look at this and take it into account before committing to borrow money. Do some window shopping and try and choose a company with as low APR as possible to make it a lighter job to repay. You would be amazed how extortionate some can be. 

Loans will often have either a fixed rate or a variable one. Fixed means a guarantee that the interest payment will not change. Variable means that the APR rate could change at any point. 

In terms of managing finances, opting for a fixed APR might be your best option.

Related Article | 11 Investment Risks You Need To Watch Out For In Your Portfolio

How to Manage Paying Principal and Interest Balances

If you can calculate how much of your payments are going toward interest, you can work out how much you need to pay to lower the principal balance. 

The money you pay back each month will likely go to interest first. Looking at the example above, if you paid $100 a month, this would only cover interest and not principal balance. 

Naturally, the more you pay off each month, the quicker your initial loan balance will reduce. Paying off debt as quickly as possible is ideal because you have less chance of stacking up a large amount of interest over time. 

Interest-Only Repayments

When it comes to saving money and knowing your options, it’s worth analyzing the different options for principal and interest repayments. Let’s see the pros and cons of this kind of interest-only repayments.

Pros

  • Potential tax benefits with investment loans

  • During this period, the entire sum of the monthly payment can qualify as tax-deductible.

  • Mortgage payments will be lower for a certain amount of time, which may work best for your current financial situation.

Cons

  • The principal amount will not reduce during this period. 

  • The loan is likely to take longer to pay off as a whole.

  • The initial balance will be more money when it comes to paying that off, for which some people may not have prepared.

Principal-Interest Repayments

Pros 

  • Interest is lower over the life of the loan.

  • Interest rates are lower overall than interest-only lending.

  • You can pay your entire borrowed amount faster.

Cons

  • Repayments will be higher than interest-only.

  • For investment loans, it might not be as tax-efficient.

Refinancing 

If you are struggling with the debt you owe, refinancing could be a viable path. Paying off debt can be overwhelming. It’s sometimes difficult to put money towards the initial balance you owe, as opposed to just interest.  

When you begin to take out loans to pay off other borrowed money, the situation can get hard to control. Through refinancing, a borrower can merge all loans under one lender. Instead of having a load of different debts, with extra charges, having it all in one makes it more digestible. Refinancing is also likely to lower your interest fees, too. 

Related Article | 3 Tips that Can Make Student Loan Refinancing Unnecessary

How Can I Save Money on Repayments?

Choosing the right kind of repayment scheme for you isn’t always the best way to keep money in the long run. Yet, by managing repayments with control and correct information, you should have a better chance of paying them off quicker.  

Principal-interest, repaid with a reasonable amount each month, might be the best option to reduce accumulating fees. Should it become necessary, refinancing will save you money on high interest rates. 

If you are still struggling with these sorts of financing schemes, it’s worth looking into some more alternatives. 

  • Community housing - See if you qualify for these kinds of housing schemes that offer reduced fees. This option is viable, especially for first time home buyers/immigrants in the US. 

  • Take time to save - It’s not always easy to save your money when you need a loan to survive. Try to save a bit of money before investing in a home or taking out a loan for your education. With the saved money - especially for mortgages - you can make a larger downpayment, reducing your borrowed amount.

  • Shop around - Don’t jump into anything. Look for terms and features that suit your budget. Fixed-rate mortgages are likely to help you plan better. 

Related Article | An Immigrant's Guide To Building A US Credit Score

Make Strategic Principal vs. Interest Decisions

Now you know a bit more about the difference between principal and interest loans, you can hopefully take some steps in the right direction to pay back money and do it smartly. Immigrating to a new country can be a lot to take in as it is, let alone with the added stress of finances. 

It’s essential to plan and pay strategically with loans. Also, knowing what options are out there for you can make it all a more manageable process.

MYRA provides personal finances for international and multicultural families in the United States. Our services include financial planning, investment management, and tax preparation. 

To learn more Click Here. To get started Click Here.