Dinero Teens: Understanding Principal vs. Interest: What You Need to Know
When you borrow money—whether for a car, a house, or even a student loan—you don’t just pay back what you borrowed. Lenders charge you extra money for lending it to you. This is where principal and interest come in. But what do these terms mean, and why do they matter?
What Is Principal?
The principal is the original amount of money you borrow. If you take out a $1,000 loan, your principal is $1,000. When you start paying off your loan, part of your payment goes toward reducing this principal amount. The more you pay toward the principal, the faster you’ll pay off your loan.
What Is Interest?
Interest is the cost of borrowing money. Lenders charge interest as a way to make money from lending. You must pay a percentage of your loan on top of the principal.
For example, if you borrow $1,000 with a 5% annual interest rate, you’ll owe an extra $50 per year in interest (assuming simple interest). Simple interest is calculated only on the original amount you borrowed (the principal), so the interest stays the same each year.
However, many loans use compound interest, where interest is calculated not just on the principal, but also on any previously earned interest. This means the amount you owe can grow faster if you don’t make regular payments. Another common type is amortized interest, often used in car or mortgage loans, where your monthly payments include both interest and principal, but early payments go mostly toward interest.
This means if you only make the minimum payment, most of your money might go toward interest instead of reducing your actual loan balance—making it take longer and cost more to pay off.
How Do Payments Work?
When you make a loan payment, your money goes toward both interest and principal. At first, a larger portion of your payment covers interest, and a smaller portion goes toward the principal. Over time, as the principal decreases, less of your payment goes toward interest, and more goes toward reducing your loan balance.
Why Credit Unions Can Save You Money
Where you borrow money matters! Credit unions typically offer lower interest rates than banks because they are not-for-profit organizations. Unlike traditional banks, which aim to make a profit for their shareholders, credit unions return their earnings to members in the form of lower loan rates, higher savings rates, and fewer fees. This means if you borrow from a credit union, you could pay less interest over time and save more money while paying off your loan faster.
Why Does It Matter?
Understanding principal and interest can help you:
- Pay off loans faster: Making extra payments toward the principal reduces the total interest you pay.
- Save money: The lower your principal, the less interest you’ll owe.
- Make smart borrowing choices: Knowing how interest works can help you compare loans and choose the best deal.
When borrowing money, always consider both the principal and interest. If you can, make extra payments toward your principal—it’ll save you money in the long run!
