When taking out a business loan, you as the business owner need to get an understanding of the repayment schedule. Part of this is understanding principal payments and the amount owed. This is why we've compiled this short guide to calculating the principal payment.
What is a principal payment?
When you take out a loan, your repayment is made up of two key components:
- Principal: The original amount of money you borrowed. Each time you make a loan payment, a portion goes toward reducing this principal balance, lowering the total amount you still owe. The faster you pay down the principal, the less interest you’ll pay over time.
- Interest: The cost of borrowing, usually calculated as a percentage of the loan amount. While making principal payments reduces the total loan balance, it does not immediately lower the amount of interest charged. Instead, interest is recalculated based on the remaining principal balance, meaning you may still owe significant interest early in the loan term.
A principal payment specifically refers to the portion of your payment that directly reduces the outstanding loan balance. Understanding how principal payments work is essential for managing loan repayments effectively and minimizing interest costs over time.
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How do principal payments work?
When repaying a loan, there are two repayment options to choose from: even principal payments and even total payments. Each option affects how much interest you pay over time and how your payments are structured.
Even principal payments
With even principal payments, the amount applied to the loan’s principal remains the same each period, while the interest payment decreases over time. Because interest is calculated on the remaining loan balance, it gets smaller as the principal is paid down. This method reduces the total interest paid over the life of the loan. However, monthly payments start off higher and gradually decrease as interest charges become smaller.
Even total payments
With even total payments, the total payment amount stays the same throughout the loan term, but the portion applied to the principal increases while the interest portion decreases. In the early stages of repayment, a larger share of the payment goes toward interest, with the principal portion gradually increasing over time. This method provides predictable and consistent monthly payments, making it easier for budgeting. However, it results in higher overall interest costs compared to even principal payments.
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Principal-only payments
- Define principal-only payments and explain how they work.
- Discuss the benefits of making extra principal payments
- Include a real-world example of how an extra principal payment affects a business loan.
How to calculate monthly principal payments
It is crucial to understand how to calculate your business's principal payment. Loan repayments can be scary if you as the business owner do not keep an eye on the interest payment. The formula for calculating the monthly principal payment for your business is as follows: a / {[(1+r)^n]-1]} / [r(1+r)^n] = p.
In this, "a" stands for the total loan amount, "r" for the periodic interest rate, "n" for the total number of payment periods, and "p" for the monthly payment. However, you could also use a principal payment calculator to identify monthly payments.
These calculators can be used easily, as long as you have certain information, such as the loan amount, interest rates, payment frequency, etc.
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Tools to help you manage loan repayments.
- Loan repayment calculators - Provide quick estimates of monthly payments based on loan terms.
- Financial forecasting tools - Help businesses plan ahead and ensure they can meet upcoming loan obligations (this is where Futrli should be mentioned).
- Automated payment systems - Reduce the risk of late payments and penalties by ensuring timely repayments.