What is a Principal Payment?
A principal payment is a payment toward the original amount of a loan that is owed. In other words, a principal payment is a payment made on a loan that reduces the remaining loan amount due, rather than applying to the payment of interest charged on the loan. In accounting and finance, a principal payment applies to any payment that reduces the amount due on a loan.
Bond Principals are further analyzed on CFI’s Fixed Income Fundamentals Course.
Understanding scheduled principal payments
Now that you have a basic understanding of principal payments, it’s important to delve into the mechanics of how they work. When making repayments on a loan, there are two basic options:
- Even principal payments – With an even principal payment loan, the principal payments will be the same in every period. For example, if you have a £20,000 loan that amortises over the course of 10 years, the principal payments will amount to £2,000 each year, with no variation.
- Even total payments – When it comes to even total payments, the total payment amount is the same in every period, but the principal will differ. With these types of loans, the principal payment usually increases over time, while the amount of interest decreases.
Although lower principal payments at the beginning of your loan repayments may look like an attractive option, making equal principal payments throughout the term of your repayment schedule could actually yield lower interest rates, meaning that you’ll end up paying a lower amount than you would with an even total payments schedule.
Advantages of Principal Payment
- Early payment saves interest for the period.
- Reduced debt increases the free cash available to equity shareholders of the company or, in the case of an individual, free cash for himself in the form of saved interest.
- In the case of a company, it leads to a healthy balance sheet on account of reduced debt levels.
- Ideal for cash-rich companies with no further projects to invest in
Disadvantages of Principal Payment
- In cases, the cash used to pay the principal portion can sometimes be used for better alternatives.
- It is important to consider different projects and their NPV before taking a decision on principal repayment, which sometimes could go wrong.
- Sometimes the bank charges a notional fee when the borrower makes a principal repayment.
Principal payment leads to accelerated repayment of the loan and reduces the amount due. The equated installments have two components- The interest component and Principal component. The principal component is toward the actual amount due, unlike the interest component in which the bank charges the borrower.
Principal payment has its own pros and cons. It could be advantageous, while at times it could be disadvantageous. It is important that the amount used to pay off liability is not better off being used in a project which earns more than the interest saved. It is very crucial to consider the time value of money while making such decisions.