Making extra payments on the principal balance allows a borrower to pay a mortgage early.
A principal balance is, in its most basic form, the outstanding amount of a loan that needs to be paid off to pay off the debt. It does not take into account future interest or fees that will accrue. The principal balance is equal to the total amount of money initially borrowed minus what has already been paid against it, without adding any of the interest that needs to be paid.
The payment amount on a loan allocated to the principal balance is detailed in an amortization schedule.
It is best to illustrate this concept with an example. If one takes out a mortgage of $100,000 US Dollars (USD) at six percent interest, the initial principal balance is $100,000 US Dollars. Each month, the borrower will make a payment to the mortgage lender. A large part of the payment will go towards paying the accrued interest, while the remainder of the payment will begin to amortize the principal balance. Over the months, the payment amount will remain the same, but a larger portion will go towards the principal payment.
The amount borrowed to buy a home is the principal balance of the mortgage, which will decrease as payments are made.
The loan is paid off when all of the principal is paid. This process of making interest/principal payments is known as amortization and is common for mortgages and auto loans. Loan interest is levied on the principal balance amount. Each month, the borrower will normally receive a statement that includes information about the remaining principal balance, although this can be easily determined by looking at an online repayment schedule. To pay off a loan in full, you must call the lender and request a repayment amount of the principal balance along with any additional interest or fees.
In a compound interest loan, the amount of interest accrued each month is added, or compounded, to the principal amount. This means that the principal amount will actually increase and interest will be calculated based on this new higher amount. When applying for a loan, be sure to read all the documentation carefully. Compound interest is common on credit cards.
A simple way to pay off a loan early is to make a larger payment than you owe. Check with the lender, but in most cases, the extra payment will automatically be applied to the principal. For example, if the amount due in one month is $300 USD and the amount paid is $350 USD, then that extra $50 USD is applied directly to the principal to decrease the total amount owed on the loan. Some loans may incur prepayment penalties, so again, be sure to read all loan documentation carefully.