Getting money from a loan is just the start of a journey that will affect your business’s taxes, accounting, and budgeting until the loan is fully paid back. Therefore, understanding business loans and, more specifically, the concept of the loan principal is crucial for small business owners.
The truth is, when you take out a loan, you actually pay back two different things: the loan principal and the loan interest.
Here, we’ll explore what loan principal is, how it can affect your monthly payments and taxes, and what you can do to pay it back faster.
What Is Loan Principal?
The loan principal is the actual amount of money that you borrow from a lender, while interest is what the lender charges you to borrow that money. When it comes down to it, interest is how the lender makes a profit by lending you money. Your interest rate is usually a percentage of the loan principal.
That said, loan principal applies to all forms of debt, whether it’s a mortgage, a small business loan, a student loan, a car loan, or a credit card balance. Knowing your loan principal gives you a better understanding of how much you actually owe the lender.
When you start to pay back a debt, the debt’s overall balance includes the principal, the interest accrued on that principal over time, and any additional fees and charges imposed by the lender. These all contribute to the overall cost of debt—in other words, a borrower will pay back significantly more than the loan principal over the entire term of the loan.
Overall, lenders typically set up payment schedules so that you pay interest payments first, then the principal—so that as you pay off the principal, the interest rate is levied against the smaller remaining amount. Therefore, the lower your principal, the less you’ll pay in interest.
How Loan Principals Work
Lenders typically want you to spend more on interest, which is why making a lower payment for a longer loan period is often not the most cost-effective solution for your business.
When you close a loan, the lender amortizes the loan, spreading your payment schedule over time so that you always have the same monthly payment. This way, you can plan your finances around this extra monthly (or weekly) fixed expense.
Your loan amortization schedule, or your monthly loan statement, will show you a breakdown of your principal balance and how much of each payment will go toward the principal and interest.
Later in the loan schedule, a greater percentage of your payment will go toward lowering the principal because interest rates are generally paid first.
Loan Principal Payment Example
Here’s a basic example:
You take out a $5,000 loan to buy a commercial refrigerator, contributing $1,000 as a down payment. The initial loan principal is $4,000. The bank charges an annual interest rate of 5%.
- Month 1: Principal is $4,000, interest is (4,000 x (.05 / 12)) = $16.67
- You pay $250, of which $16.67 goes to interest and the remaining $233.33 goes to the principal, bringing the principal down to $3,766.67.
- Month 2: Principal is $3,766.67, interest is (3,766.67 x (.05 / 12)) = $15.69
- You pay $250, of which $15.69 goes to interest and the remaining $234.31 goes to the principal, bringing the principal down to $3,532.36.
And so on, and so forth. As you can see, you will continually be charged interest, even though it will be a smaller amount each month. Those recurring interest payments often incentivize borrowers to pay off the loan principal faster.
How to Pay Loan Principal Faster
Most lenders will let you make additional principal payments in order to pay off a loan faster than the initial payment schedule. Making extra principal payments will reduce the amount of interest you’ll pay over the life of the loan, whether it’s a small business loan, a mortgage, or any other type of loan.
If you’re interested in paying off your loan faster, you should talk to your lender. Each business loan agreement will have different terms and conditions and different lenders apply extra payments differently.
Some automatically apply extra payments to interest first. On some loans, you may be able to make principal-only and interest-only payments, allowing you to pay down the principal faster.
However, there may also be prepayment penalties for paying off the loan before the expected payoff date, so be sure to check that too before making extra payments.
How Loan Principals Affect Taxes
The principal and interest on a loan affect your business taxes and personal taxes in different ways. Individuals may be able to deduct the amount of interest they pay depending on the type of loan; however, payments toward the loan principal are not usually tax-deductible.
The principal amount of a business loan is typically tied to an asset, like a company car or that aforementioned commercial refrigerator. Since the asset’s value depreciates over its lifetime, you can’t deduct the full principal from your taxes unless it qualifies as an “ordinary and necessary” expense in your industry.
You can, however, deduct the interest you pay on business loans each year. Use our guide to learn more about business loan interest tax deductions.
The Bottom Line
The loan principal is the actual amount that you borrow from a lender. However, when you start paying the loan back, you’re paying more than just the loan principal—you’re also paying interest.
Since interest is levied against the loan principal, it can be beneficial to pay down the loan principal faster than your original loan schedule. But, there may be restrictions on early or extra payments—so be sure to consult your lender.