QandAs: Loans

What is the Principal of a Loan?

Answer:
Loan principal is the portion of the monthly

payment that reduces the balance. Throughout the initial loan years, a large portion of scheduled monthly payments goes toward the interest, wherein the loan balance or principal remains almost the same. For this reason, loan principal is best described as the difference between the payment and the interest due.

Over time, the interest due on a loan progressively declines. When this happens, principal payments start to exceed the interest due, and the loan balance reduces at a faster rate. This is called amortization.

Full amortization and negative amortization refers to the unpaid balance on a loan. On a fixed rate home loan, fully amortized payments are determined at the outset, and do not change throughout the life of the loan. Thus, borrowers will payoff the loan balance with the 360th payment. In order for an adjustable rate loan to remain fully amortized, a slight interest rate increase will result in a payment jump. In contrast, negative amortization occurs when schedule payments are less than the interest due, and the loan principal increases each month. Mortgages that result in negative amortization include option-ARMs and a variety of other loan programs that offer flexible or low monthly payments.