As adults, we are no strangers to the world of finance and basic terms that we have to deal with to keep our financials healthy. Our experience with finance starts off most of the time at college where we probably have student loans. Later on, in life, we will be getting credit cards, auto loans, and sooner enough — mortgages!
Knowing all of the terms and basic concepts in finance is really important because it will help you know exactly what you are getting into when you take out a loan or a line of credit of some form. When you take a look at people who default on their loans, it is not that they never had the intention of repaying their balances, they just didn’t know how everything worked so they wound up being surprised.
You have probably seen a lot of students complain about having to pay more for their student loans than what they took out initially. This is just one of the things that could have been avoided with better awareness. One of the reasons is that they thought they would be paying only a certain amount is that they focused only on principal payments. So what is a principal payment and why is it so important to know how they work? Let’s find out now.
What is it?
When talking about principal payments some people like to use the term “face value”. This is because this is the number that is initially associated with a loan. If you take out a mortgage for $500,000, for example, then the principal balance for that mortgage is, you guessed it, $500,000.
Of course, looking only at the principal balance is not the full picture. There are other things that you need to consider, especially interest. Over time the total balance for the loan will look dramatically different from the principal balance, so it is good if you know how to distinguish the two especially if the loan has compounding interest rather than simple interest.
How does interest affect it?
The biggest reason to pay attention to principal balances is that they are changed dramatically by interest over time. Maybe not so dramatically when it comes to simple interest, but with compounding interest, you will quickly find out why it is so much better to start chopping away at the balance by making principal payments.
You see, a principal balance is affected by simple interest only slightly because the amount that simple interest considers the “principal” amount will always only be the initial amount of the loan. If you took out a loan for $10,000 and your terms offer you 10% annual interest, then only $100 will be added to that principal balance every year. If the same balances apply but with compounding interests, however, the principal balance is considered to be the old amount plus the new amount when interest is accrued. If you have $10,000 and you have 20% interest per year, that means your original principal balance is $10,000 but in the next month, your principal balance will be around $10,166. The month after that, the principal balance will be even larger.
As you can probably tell, simple interest will not increase the amount of your loan very much but the more common compounding interest has the potential to significantly increase it.
Why should I make principal payments?
You should start paying principal payments based on what we learned here because you do not want compounding interest to make the loan bigger than what you can afford. Start shipping away at the principal balance of your loans and your future will be debt-free sooner rather than later!