Principal vs Interest and Debt
For the most part, debt consists of principal and interest. Typically, you don’t get to choose how much you will pay for each—the lender will do that for you. However, understanding the difference between the two and knowing how to focus more on principal and less on interest will help you escape debt quickly and cheaply.
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Millions of Americans are trapped in a seemingly endless cycle of debt because they don’t fully understand how the process works, where their money is going, and how they can banish endless debt and cut-short prolonged payment terms.
In this guide, we’ll show you the ropes, telling you the differences between interest and principal, and showing you why making only your minimum payments could trap you in an endless cycle of debt.
What is the Difference Between Principal and Interest?
The principal is the money that you borrow and the interest is the lender’s charge. If you borrow $10,000 at 20% APR, then theoretically, you will be charged $2,000 on that balance over the course of a year. This means you will have a balance of $12,000, with $10,000 being the principal and $12,000 the interest.
The lender will create a minimum monthly payment, which is the amount you need to repay every month to avoid late payments and defaults. This amount is often calculated as a total of the balance, including both interest and principal.
The reason so many debtors find themselves in seemingly inescapable debt is because the interest can compound on a daily basis.
Examples of Principal vs Interest
To understand what we mean by “inescapable debt”, let’s look at a few examples and show you just how much of your monthly payment is going towards the interest and not the principal.
Credit Card Principal vs Interest Example
Credit card interest rates are advertised as “annual percentage rates” but they are actually charged on a daily basis. To calculate what you’re being charged every day, just take your advertised APR, divide it by 365 (number of days in a year) and then multiply by your debt. An interest rate of 20.50% and a debt of $10,000, for instance, would look like this:
- 0.2050 / 365 = 0.00056
- 0.00056 x 10,000 = $5.6
Over the course of a single billing cycle (30 days) you’ll pay $168 in interest. This means that your balance will be $10,168 at the end of the month. From here, the creditor will calculate your minimum payment, often as a percentage (between 2% and 5%) of the total. If we assume a minimum of 2%, it creates a monthly payment of $203.
This means that just $35 of your monthly payment actually goes towards the principal, while the rest is interest. The reason credit card debtors find themselves trapped in an endless cycle of debt is because only a fraction of what they repay actually goes to the principal. It’s the financial equivalent of taking two steps forward and one step back.
Mortgage Principal vs Interest Example
Many first-time homeowners rush into getting a mortgage because they feel like they’re throwing their money away by renting and believe it would make more sense for that money to go towards a mortgage. To an extent, this is true, but probably not as you would expect.
The truth is, the first few years of your mortgage are spent repaying interest, with only a fraction of your payment going towards the principal. If you rush into buying a home and acquire high-interest rates just to own some real estate, you could be doing more harm than good.
It makes much more sense to wait, get the right rates, and put yourself in a position where you can consistently pay more than the minimum or cover a higher down payment.
If you borrow $200,000 over 30-years and with a 5% interest rate, you’ll be expected to repay $1,073 a month. For your first repayment, $833 will go to the interest and just $240 will go to the principal. Every month this will change slightly, so that after two years you’re paying $808 in interest and $265 in interest, but it will take approximately 16 years before a greater proportion of that money is being spent on the principal.
By the end of the mortgage, everything has flipped and most of your payments go towards the principal, but in those early years you’re barely making a dent on your balance. In fact, you need to make over $40,000 of payments over the course of the first 40 months just to bring your initial balance down by $10,000.
How to Pay More of the Principal
Most lenders accept principal-only payments, but these can only be made once your minimum payment has been covered. You shouldn’t have an issue making these payments on a credit card balance or mortgage, but you should check with providers of personal loans as they may penalize you for making them.
When you make a minimum monthly payment, you’ve covered the necessary interest for that month and have completed your minimum obligation. If you pay more in the same period, most, if not all of that money will go towards the principal.
This will reduce the term of your loan and allow you to repay it quickly. Where credit card debt is concerned, it will also reduce the total interest you will repay. Even a small addition to your monthly payment could save you thousands over the term.
Let’s return to the previous example of a $10,000 balance and a 20.50% interest rate. This debt will take 109 months to repay in full and you’ll pay over $12,000 in interest on that $10,000 debt. If you increase your monthly payment by just $50, roughly 25% of the minimum, it will clear in just 67 months and you’ll pay around $6,000 less interest.
A small amount makes a massive difference because, in some cases, it could double the amount of the principal that’s being repaid every month.