Principal and interest: what each payment does

Resources · Cards, loans and credit · 4 min read Building

Key points

• Principal is the amount you borrowed and still owe. Interest is the charge for borrowing it.
• Each payment pays the month’s interest first, then reduces the principal.
• Only the principal part brings your debt down.
• Extra money paid on top of the regular payment often goes to principal, but check how your loan applies it.

The difference between principal vs interest is simple. Principal is the debt itself. Interest is the price of borrowing it. Every regular payment covers that month’s interest first, and only what’s left over reduces the principal.

That’s why two payments of the same size can do very different amounts of good. What counts is how much of each one actually reaches the principal.

The two parts of every payment

Picture your payment filling two buckets, in order.

1. Interest bucket. This month’s interest is worked out on the principal you still owe. It’s filled first.
2. Principal bucket. Whatever’s left of your payment goes here and reduces what you owe.

Next month, interest is worked out on the new, lower principal. So the interest bucket shrinks a little and the principal bucket grows a little. That slow shift is called amortisation. Our guide to what amortisation means for your loan walks through a full schedule.

Principal vs interest over a loan’s life

Here’s how the split changes on one loan. The same maths works in any currency.

Assumptions: a $25,000 car loan at 7% a year, fixed (monthly rate = 7% ÷ 12), over a term of 60 monthly payments. Interest is charged on the balance each month before the payment, and the last payment is whatever clears the balance.

The monthly payment is $495.03.

The last payment is $495.05, two cents more than the others, because it clears exactly what’s left.

In month 1, about 29% of the payment goes to interest. By the final month it’s well under 1%. Over the whole loan, total interest comes to $4,701.82.

What an extra payment does

Extra money paid on top of your regular payment often skips the interest bucket and goes straight to principal, as long as the loan allows extra payments. Some loans apply extra money to future payments instead unless you choose otherwise, so check your loan terms. Every month after that, the interest charge is smaller.

Take the same loan. Pay one extra $1,000 in month 12 and keep the regular payment the same. The loan then finishes after 58 payments instead of 60, and total interest falls from $4,701.82 to $4,386.46. That’s a saving of $315.36.

Notice the extra $1,000 doesn’t save $1,000 of interest. It saves the interest that $1,000 of principal would have collected over the remaining months. So the earlier you pay extra, the more it saves, because there are more months left for the saving to build.

Some loans charge a fee for extra or early payments, and some cap how much extra you can pay. The loan terms set this out. Some people put spare money towards principal. Others keep it as savings for emergencies. Which suits you depends on the loan’s rate, its rules and how much of a safety net you have.

Principal and interest on credit cards

Cards run on the same idea, with a twist: there’s no fixed schedule. Each month, interest is charged on the balance, your payment covers that interest first, and the rest reduces the balance.

Pay only a small minimum and most of it can go to interest. The principal barely moves. Put new spending on the card and the principal grows even while you’re paying. Why minimum payments take so long covers that side of things.

Principal and interest vs interest-only

Some loans, often home or investment loans, offer an interest-only period. During that time your payments cover just the interest. The principal stays exactly where it is.

Interest-only means lower payments for a while. But the debt doesn’t shrink, and payments usually go up when the period ends, so check your loan terms. Principal and interest means higher payments from the start, though the debt falls every month and total interest is usually lower.

Neither suits everyone. It depends on your budget now, what you expect later, and how comfortable you are watching a balance that isn’t moving.

Common questions

Is it better to pay principal or interest?

With a regular payment you don’t get a choice. Interest is covered first, then principal. Extra payments, where allowed, usually go to principal and cut future interest.

How do I know how much of my payment is principal?

Loan statements often show the split. If yours doesn’t, multiply what you owe by the yearly rate, divide by 12, and subtract that from your payment.

Why does my principal go down so slowly at first?

At the start you owe the most, so the interest charge is at its biggest and takes a larger share of each payment.

Try it

See the split for your own loan in the loan repayment calculator. To see all your debts together, find your Freedom Date.

General information only, not financial advice. Your situation is your own.