Principal is a term used to describe the amount owed on a loan or mortgage and it is often known as your balance or capital. Interest is the charge levied by the lender to the borrower for facilitating the borrowing. Your loan balance and the interest charged are inherently linked, as interest charges are expressed as a percentage of the outstanding balance, or principal.
The advantage of paying off principal compared with interest is that it will reduce your balance and therefore result in less interest being charged in the future. The advantage of paying interest rather than principal is that it will result in a lower payment being required, which can help cash flow. Principal is the amount that you owe, whereas interest represents the cost of borrowing that money. They are closely connected as the amount you owe and the amount of interest that you are charged are directly correlated.
What are the differences between Principal vs. Interest Payments?
Principal payments reduce your mortgage balance, whereas interest payments settle the interest due. In practice, on capital repayment mortgages, both interest and principal are repaid in one combined monthly payment. This means that your monthly payments cover all of your mortgage obligations.
As your interest is paid through your monthly payments, any additional overpayments that you make will directly reduce your mortgage balance.
In some cases, principal and interest payments may be made separately, as is often the case with overdrafts.
When is an interest payment more advantageous than a principal payment?
Paying only interest instead of principal is beneficial if you’re looking to keep your monthly payments low to protect your cash flow. Interest payments are almost always required on loans and must be maintained to keep within the lender’s mortgage conditions. As such, it’s important that as a minimum, your mortgage interest is paid on time to avoid formally falling into arrears.
While it’s important to pay the interest, the principal must also be paid to stay within the good graces of your mortgage lender if your loan was taken on a capital repayment basis. You can learn more about this on our principal payment definition page.
When is a principal payment more advantageous than an interest payment?
Principal payment is more advantageous than paying only interest when you’re looking to reduce your interest in the future. This is because the interest charged is based on your outstanding mortgage balance, as is explained in our interest rate definition article. Additional principal payments allow you to reduce your outstanding balance and therefore the amount of interest that is being charged on your mortgage. This can have significant advantages as each overpayment, or principal payment reduces your borrowing costs and takes you one step closer to repaying your mortgage.
What are the calculation differences between Interest and Principal?
A mortgage of £200,000 at an interest rate of 3% would attract monthly interest of £500. Should the borrower choose to make an overpayment of £20,000, this would reduce their balance to £180,000. As the balance has reduced, the interest due would also reduce. In this example, on a balance of £180,000, the borrower’s monthly interest would reduce to £450 – a saving of £50 per month.
Calculating Interest Payments
The above example can be calculated using the following calculation:
Mortgage balance x interest rate (as a percentage) / 12 (for a monthly figure)
This becomes £200,000×3%=£6,000
Calculating Paying Down Principal Balance
Taking the example above further, the overpayment of £20,000 reduces the balance to £180,000 from the original £200,000.
The calculation then becomes the following:
Is making larger payments better for principal payments?
The larger your principal payment, the more interest you’ll save. As such, the more you overpay, the greater your savings. The exception to this is where your mortgage has early repayment charges, also known as ‘penalties’ for overpayments. In this scenario, a penalty may make your overpayment uneconomical if the cost of paying the penalty is higher than the amount of interest saved.
What should you do if you have multiple debts with high interest rates?
Multiple debts refers to when a borrower has borrowed money using a number of separate financial accounts. When faced with a number of debts at higher interest rates, it’s important that you use your funds wisely to maximise your interest savings. The best way to handle this situation is to pay off the loans with the highest interest rates first. This will allow you to reduce your interest costs faster than any other method.
Once this is done, you should compare products from different lenders to check whether you could reduce your interest costs further by refinancing your loan or mortgage.
How do I calculate how loan interest and principal payments affect my loan term?
The easiest way to calculate how your loan term is influenced by principal payments is to use a loan calculator. Many borrowers reduce their loan balance while keeping their monthly repayments the same, which reduces their loan term and reduces their interest costs. When using a loan calculator, the simplest way is as follows:
1. Input your loan balance, interest rate and remaining term
2. Reduce your balance to what it will be after the overpayment has been made
3. Incrementally reduce the loan term until your monthly payments become the same as your current monthly payments
Once your payments are the same, the loan term in the calculator represents how long it would take to repay the loan at your current monthly payment.
The most common mistake when calculating interest payments on loans that are arranged on an interest only basis is to assume that the loan will be repaid at the end of the term. Without additional principal payments, or capital overpayments, this is not the case. As such, it’s important that you check whether your loan is capital repayment or interest only.
Is additional principal payment logical for car loan payments?
Overpayments, also known as principal payments are often beneficial for borrowers with car loans as car loan lenders don’t usually charge early settlement penalties. This allows you to make overpayments, reducing your interest costs without any additional charges. A car loan calculator can be used to calculate your interest savings based on your individual circumstances.
Does your interest rate harm the financial well-being of a family for mortgage loan?
As interest rates increase, so do your monthly mortgage payments. This can impact borrowers’ financial wellbeing, especially when variable interest rates rise unexpectedly. An interest rate rise of 0.25% increases annual interest costs by £250 for every £100,000 borrowed. Of course, rises beyond this level can add up quickly, especially for larger mortgages. When calculating how interest rates could impact your monthly payments, a mortgage calculator can help you to understand multiple scenarios quickly.