What Is Loan Principal and Why Is It Important?
If you decide to accept a business loan offer, it’s important to familiarize yourself with loan principal first. In this post, we’ll take a closer look at what a business loan principal is, how it works, and where to find it.
Loan Principal Definition:
Put simply, a loan principal is the amount of money you borrow from a working capital lender when you take out a business loan. If you opt for a $40,000 loan to buy equipment, for example, your initial loan principal is $40,000.
Generally speaking, your loan balance will be made up of your principal and any interest charges accrued on it. Therefore, even if your loan principal is $40,000 initially, interest may make your balance higher. As you reduce the amount of your loan balance, your principal will go down. Once you’ve repaid the original amount completely, you’ll be left with a principal of $0.
Loan Principal vs. Loan Interest
While the loan principal refers to the amount you borrow, the interest is the cost of borrowing that money. After all, banks, credit unions, and other business loan lenders need to profit somehow and don’t lend out money for free.
Your loan principal will be a dollar amount, whereas your interest will be a percentage. Therefore, your amount of interest owed will depend on your business credit history and your lender’s unique policies.
In most cases, a higher credit score and stronger credit history leads to a lower interest rate. Therefore, you should build good credit before you take out a business loan.
How Does a Business Loan Principal Work?
Let’s go back to the $40,000 equipment loan example mentioned previously. While your initial loan principal in this scenario is $40,000, your business loan lender will charge you an annual interest rate of 6 percent.
When you finally receive your loan proceeds and make your first payment, your loan principal will still be $40,000.
However, you’ll be required to pay interest of $200 ($40,000 x (6%/12). If your monthly payment is $800 per month, $200 of it will take care of the interest and the remaining $600 will go toward your principal.
After you make your first payment, your loan principal will go down to $39,400. It will keep decreasing until you no longer owe any money on your loan.
How to Determine Your Loan Principal
Once you take out a business loan and start repaying it, you’ll receive a monthly statement online or via mail. The statement will likely have a breakdown of how much you owe toward your principal balance and how much you owe toward interest. If you have difficulty determining where your monthly payments are going, don’t hesitate to reach out to your business loan lender and ask.
Can You Pay Down the Loan Principal Faster?
Fortunately, most business loans allow borrowers to make extra payments so they can repay their loan faster. Your lender may accept principal-only payments that reduce the principal but not the interest. If you have the extra money to do so, paying down your loan principal faster can be a smart move. It can allow you to:
1. Save on Interest Payments
By making additional payments on your principal, you can reduce your interest payments over the life of your loan. This is because your interest depends on your remaining loan balance.
2. Shorten Loan Term
Just because your equipment loan is for two years, for example, doesn’t mean you have to spend that much time repaying it. With extra principal payments, you can shorten the length of your loan. Once it’s paid down, you’ll have more money at your disposal, which will benefit your business.
3. Gain Peace of Mind
The less debt your business takes on, the better it will be for your business’s overall finances. If you’re overwhelmed with all your monthly payments, paying down your principal as soon as possible can give you some much needed peace of mind.
How Does Loan Principal Affect Taxes?
As a small business owner, you’re likely always on the lookout for ways to save on business taxes. Therefore, you may wonder how your loan principal will affect them. Often, you can deduct the interest you pay or accrue on your business loan.
Unfortunately, however, you won’t be able to deduct the loan principal. This is because you’ll use the principal for your business and pay it back. Unlike interest, loan principal isn’t considered income for your business; it’s not money you’ve earned.
Conclusion: Read the Fine Print Before Taking Out a Business Loan
Before you sign on the dotted line and accept a business loan offer, make sure that you fully understand the principal, interest, and monthly payments. It’s also a good idea to compare business loans from various lenders to ensure that you land the best deal. By doing so, you can save thousands of dollars over the life of your loan.
Editor’s Note: This post was updated for accuracy and comprehensiveness in September 2021.
Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author's alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.