Principal vs. interest: What’s the difference?

When you take out a loan, the amount you borrow is the principal. Interest, which is charged by the lender, is the cost of borrowing money. Part of your minimum monthly payment typically goes toward paying off the interest that’s accrued since your last payment. And if the payment is for more than the interest, the remainder will pay down your account’s principal balance. 

Understanding how the principal balance and interest differ and interact can be helpful when you’re managing debt.

What you’ll learn:

• The principal balance on a loan is generally how much you borrowed and still owe. 

• Interest accrues on the principal based on the account’s terms and its interest rate, which is the cost of borrowing money. 

• Monthly payments are typically split between interest accrued since the previous payment and the principal balance.

• You can limit or avoid interest charges on a credit card by paying your statement balance in full every month.

When you borrow money, you’ll typically have a clear idea of your monthly loan payment amount. But knowing how your payments are divided between principal and interest may help you understand the total cost of your loan.

Here’s an overview of the key differences between a loan’s principal amount and interest:

A loan’s principal balance is generally the amount originally borrowed. The principal is important because the loan’s interest rate typically applies to this balance.

For example, if you buy a home for $300,000 and make a $50,000 down payment, you would need to borrow $250,000 from your mortgage company. That’s the principal amount you’ll repay over the term of the loan, plus interest.

In general, interest is the price of borrowing money. An interest rate determines how much interest a creditor charges on the amount of money borrowed. 

Here’s a basic example: Say you borrow $100 and the loan has a 10% interest rate. That means you’ll have to pay $10 in interest over the first year. 

But many loans and credit cards advertise an annual percentage rate (APR) rather than an interest rate. The APR is the annualized cost of borrowing, including certain fees. The APR can vary by the lender, your creditworthiness and the terms of the loan or credit card. 

With loans, the APR may be higher than the interest rate if the lender charges up-front fees. With credit cards, the APR and interest rate are often the same, excluding certain avoidable credit card fees.

You can calculate the amount of interest that accrues on your loan using this formula:

Simple interest = principal loan amount x interest rate x number of years in the loan’s term

You could also try to calculate APR based on the loan’s interest charges and fees. An even easier option may be to look at a recent statement. It could tell you how much of your payment went toward interest and how much went toward the principal balance.

Your monthly payments go toward your principal balance as well as interest and fees that have accrued since your last payment. But several factors can affect how much interest accrues and your resulting monthly payment. 

• Simple vs. compound interest: Many loans use simple interest, meaning the interest rate only applies to the remaining principal balance. But some loans use compound interest, which can apply to the remaining principal balance and outstanding interest.

• Fixed vs. variable rates: If an account has a fixed interest rate, the rate stays the same for the life of the loan. If an account has a variable interest rate, the rate can change and affect your monthly payment. 

• How often interest accrues: Interest generally accumulates on a daily or monthly basis. The more frequently it accrues, the bigger the impact on your monthly payment.

Monthly payments often work differently for loans and credit cards.

• Monthly payments for loans: Many fixed-rate loans are amortized, which means the loan is paid off over time in equal installments. A portion of each payment covers interest and the remainder pays down the principal balance. As the principal balance decreases, less interest accrues and a larger portion of each payment goes toward the principal. 

• Monthly payments for credit cards: Credit cards typically use daily compounding interest. Your monthly payment amount can depend on your balance, recent purchases and any fees, payments or other transactions. You can make minimum monthly payments on a credit card account, but paying your balance in full by the payment due date could help you avoid interest charges on your purchases.

Early in the life of a loan, the principal balance is at its highest, which means that interest charges will also be higher. So at first, a larger portion of your payments will go toward the interest. By the end of the loan term, most of your payments will go toward reducing the remaining principal balance.

If you’re comparing loan offers, lenders may provide you with an amortization table. This table shows how each monthly payment is split between principal and interest, with the interest portion decreasing and the principal portion increasing over time.

There are many strategies for managing debt. Some might help you save money. Others might decrease your payments today but could cost you more overall. It might help to consider which option, or options, may be best based on your goals and finances. Here are a few to consider:

• Consolidate debt. A debt consolidation loan—a type of personal loan—can be used to pay off multiple loans or credit cards. While debt consolidation doesn’t decrease the amount you owe, you might secure a better interest rate, which could result in lower monthly payments.

• Apply for a balance transfer. You could consider a balance transfer credit card to transfer balances from other cards or help pay down loans. Some credit cards offer introductory APRs on balance transfers, which could reduce the interest you pay toward the transferred balance during the promotional period. But any remaining balance starts accruing interest at the card’s standard APR at the end of the promotional period.

• Pay more toward the principal. Paying more than the minimum monthly payment on a loan could help lower your principal amount and reduce the interest.

• Contact your lender. If you’re having trouble with debt, you could contact your lender to review your options. But because lenders can handle interest differently, it’s important to pay attention to the details in order to understand whether short-term relief might end up costing you more in the long run.

The principal balance on a loan or credit card is generally the amount you borrowed. And interest can accrue on the principal based on the account’s interest rate. The more principal, the higher the interest rate—and the more frequently interest accrues, the more interest you’ll pay overall. Paying down a loan’s principal balance early could lead to paying less total interest. 

With credit cards, you can avoid interest on purchases by paying your bill in full each month or looking for promotional interest rate offers. If you’re considering a credit card, you can see whether you’re pre-approved for a Capital One card with no impact to your credit scores.