In a typical financial transaction involving credit, a party is either on the borrowing side, as a debtor or borrower, or on the lending side, as a creditor or lender. When a specific amount of money is borrowed, the amount of money owed to the creditor is known as the principal balance. Any payments on the loan that reduce the remaining amount of principal owed are therefore known as principal payments, or amortization of the loan.
In order for a creditor to benefit from lending money to another party, a specified amount of interest is charged. This rate of interest may be fixed, or static, or variable, otherwise known as dynamic, based upon the previously determined terms of the loan. The amount of interest charged is a factor of the rate of interest and the amount of principal. For example, a loan of $5,000 US Dollars (USD) principal with 20% interest charged annually will increase by $1,000 USD over the course of a year. This increase may take place over different time increments, a variable that is also dependent on the specifications of a particular loan.
Because interest is based upon the amount of principal present, the greater the principal given a set interest rate, the greater the profitability for the creditor. Contrarily, a small principal amount will possess less risk but will not result in the same amount of profit for the creditor. A decrease in principal consequently decreases the interest charged, which results in lower required payments.
It is in the best interest of the borrower to make principal payments as large as they are willing until the principal is completely paid off. The longer principal remains, the more opportunities the creditor has to compound, or charge, the loan with interest. After the principal is paid off, there may still be outstanding interest balances that need to be paid, but interest will no longer accrue due to the absence of a principal balance.
For example, if $5,000 USD is taken out and paid monthly for five years, the principal payments in order to reduce the balance to zero would be $5,000 USD divided by 60 months, which is equal to $83.33 USD a month. If the creditor is also charging 5% interest compounded monthly, the borrower is also responsible for interest payments.
At the end of the first month, the interest charged would be 5% x $5,000 USD, which is equal to $250 USD. The outstanding balance is now $5,250, $5,000 of which is principal and $250 of which is interest. If the borrower plans to pay $100 a month, $83.33 would be applied as principal payments, and $16.67 would be applied to interest. Therefore, the amount of principle would decrease to $4,916.67 USD, making the next month's interest increase equal to 5% x $4,916.67 USD, or $245.84 USD. This is a very simple example of why principal payments may decrease interest accumulation in a straight line amortization.
