What is the Difference between Principal and Interest

Difference between Principal and Interest

Here’s a Shortcut

What is the Principal? That is the amount you borrow.
What is the Interest? That is the amount charged by the lender, and that is the lender’s profit on the transaction.

Why is this important? Because there are a few options available to you when borrowing money, whether the loan is for personal reasons, investment or for a home.

Your Borrowing Options Depending on the Type of Payments

If you decide to do everything on your own, you should research all the options from which you can choose. Otherwise, you can use your financial advisor or a mortgage broker who will probably be able to answer all your questions.

One of the more popular loan scenarios is an Interest Only Loan, or a principal and interest loan. These loans are very simple to explain.

Principal and Interest Payment

As the name suggests, with a principal and interest loan you are paying both, the interest and also a portion of the principal.

Interest Only Payment

With an interest-only loan, you are just paying the interest. The lender is usually the one who sets the interest-only period, and it depends on the product, that is your loan option, you choose. Once the interest-only period has elapsed, the loan will revert to a principal and interest loan.

Why would a borrower take out an interest only loan? Here are a couple of reasons for somebody electing to do that.

  • Financial hardship: If you are struggling to meet all your financial commitments and things are getting a little tight with money, you might elect to take out an interest only loan to help get you back on your feet. That advice can be from your financial advisor or accountant.
  • Investment Strategy: When purchasing an investment property, your accountant or financial advisor may suggest an interest-only loan to minimize your outgoing payments and maximize your tax advantages. A lot depends on the conditions of your loan and in these cases, it is advisable to get professional advice.

Common Sense and Money Sense

The most popular loans, be they mortgage, personal loans or motor vehicle, are principal and interest payment loans. For owner-occupied homes, these mortgage payments are indeed the best ones to take out. These loans allow you to pay off both the principal and the interest with each payment you make.

If you opt for an interest only loan for an owner-occupied property, there is the disadvantage that at the end of the interest-only period, which is usually 5 years, you would need to make higher payments than if you had initially started with principal and interest payments.

Payment Example

Here is an example of what your repayments would be on an Interest Only loan during and after the allowed period. For this example, the interest rate is fixed, but most lenders offer the option of variable rates as well.

  • Home Loan: $330,000
  • Term: 30 years
  • Interest rate: 6.5% fixed for 5 years

For this example, the monthly Interest Only repayments equal $1625.00. After 5 years of Interest Only, the mortgage period remaining for the loan is 25 years. In comparison, monthly Interest and Principal repayments is $2025.62 (higher than in the first case).

You can compare these payment options with paying the principal and interest from the start: $1896.20 monthly.

If ever in doubt, chat with your accountant.

How about the Principal vs. Interest on Personal Loans?

You can opt to make interest-only payments on a personal loan. Again, financial hardship may be the reason. Paying interest only is something that would have to be discussed with the lender. They are interested in making sure that you can pay your loan and a short interest only payment plan can be arranged. The sooner you can get back to paying off the principal, the better.


Sources and References

1. “What is the difference between paying interest and paying off my principal in an auto loan?” Consumer Financial Protection Bureau. Accessed on September 13, 2018 from https://www.consumerfinance.gov/ask-cfpb/what-is-the-difference-between-paying-interest-and-paying-off-my-principal-in-an-auto-loan-en-845/

2. “Loan Overview” Florida SouthWestern State College. Accessed on September 13, 2018 from https://fsw.financialaidtv.com/play/2313-loan-overview/258-what-difference-between-interest-and-principal