Principal payment - What is a principal payment?
A principal payment is payment made on a loan that reduces the amount due, rather than a payment on accumulated interest
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In accounting, the term ‘principal payment’ applies to any payment made that actively reduces the amount due on a loan. While some payments involve merely managing the interest charged on a loan, a principal payment involves reducing the debt owed.
When a principal payment is made
A principal payment can be made in a number of various situations. Principal payments can be either partial amounts of the amount due, or even the full amount of the loan. For example, a principal payment can be made monthly in the form of the minimum required payment (as this includes both interest and a portion of the loan itself).
A partial payment that includes interest is considered a principal payment because it not only reduces the amount due but will also effectively reduce the interest fees for the next required payment.
The term also applies to a payment made on a loan that covers the full amount of the loan, making future payments unnecessary and ending the loan.
For Example: Tim is just starting out with a web design business and needs some new hardware and software to be able to be competitive in his market.
- Tim takes out a small business loan of £3,000
- After 6 months, business is booming
- Tim has made regular monthly payments and reduced the balance to £2,400
- After considering his finances, Tim determines he can make a principal payment of £1500, reducing the remaining amount due to just £900
- Tim sees a reduced interest rate for the remainder of his loan payments
Benefits of principal payments
Reduced interest rates are an obvious positive effect of making principal payments, but these payments have additional beneficial effects as they reduce the principal balance of the loan.
Loans with lower rates result in reduced liabilities for a business, which serves to increase the company’s profitability. This is generally seen in the balance sheet, where the impact of the reduced loan is clearly visible.
Principal payments and Debitoor
With accounting & invoicing software like Debitoor, you can create accounts to manage payments made and due on any outstanding loans that are related to your business.
Keeping track of your assets and liabilities is easy with Debitoor’s financial reports, generated with just a click.