When it comes to applying for credit, one of the challenges that people often face is understanding the long list of complicated terms and jargon. Two common terms often used in the world of banking and personal finance are principal and interest. Below, we explain the difference between the two and apply these concepts to help you manage your personal finances.
What is the difference between principal and interest?
When you apply for a credit account with a lending institution, you’ll usually be asked to sign a contract where you promise to pay back the borrowed amount.
The principal is the original amount you borrowed and have to payback. However, the lender usually specifies in the contract that they will charge an amount in exchange for borrowing money — this is called the interest.
Important related definitions
Interest – Interest is the cost of using somebody else’s money. When you borrow money, you often pay interest. Lenders may charge you different interest rates based on your credit score.
Annual Percentage Rate (APR) – When you are borrowing as a consumer, you may see the term APR, which refers to your interest rate for the entire year. For example, if your loan has an APR of 10 percent, you would pay $10 for every $100 you borrow annually.
Interest payment – When making your monthly payment, the interest payment refers to the amount of money that goes toward paying the interest charges.
Principal payment – Payment made on a loan that reduces the amount due, rather than a payment on your accumulated interest
Principal balance – While the principal is the amount of money you initially loan, the principal balance is the total outstanding balance of this amount, not including interest.
The importance of paying down your principal balance
Using a loan principal and interest calculator is a good strategy for helping you make a plan for paying down your principal balance faster. By understanding all of the terms and conditions involved with personal loans, you can get a better idea of the money you’ll ultimately owe.
When you make monthly payments to the lender, everything you pay above the interest payment amount goes toward paying off the principal. The more you deposit into the credit account, the faster you reduce your principal balance, and the less you usually have to pay in interest.
For example, if you owe a lender $50 per month in interest payments and pay off $100 a month in total, then $50 of your payment goes toward settling your principal debt, thereby reducing it.
Refinancing multiple debts
If you have several credit accounts, then the costs of interest may add up quickly. Some people choose to combine multiple credit card balances them into one monthly payment. In many cases, the new debt will have a lower annual percentage rate than the rates on your credit cards, which may make payments more manageable.
Credit card refinancing transfers credit card debt to a balance transfer credit card that often charges no interest for a promotional period, often 12 to 18 months. For most balance transfer cards, you’ll need good to excellent credit (a 690 score or higher). Many issuers will charge a balance transfer fee of 3% to 5% of the amount transferred, so before you choose a balance transfer card, calculate whether the interest you save over time will exceed or equal the cost of the fee.
Credit history and newcomers to the U.S.
If you're a newcomer to the United States, then it’s likely you’re starting your financial journey in the country with no credit history. This situation can become an issue as it may take up to 5 years to build your credit history with the bureaus.
Fortunately, Nova Credit has a partner network that can help you transfer your credit history from your home country so it can be used by U.S.-based credit institutions. This is what’s called your Nova Score, and it may help you in your application with credit providers in our partner network.
Nova Credit is the first cross-border credit bureau assisting newcomers to the U.S. so they can use their established credit history to find an apartment, open a phone plan, or get an internet service provider. In this way, Nova’s "Credit Passport®" provides a win-win situation for both lenders and newcomers.
Understanding interest and principal and how it affects your monthly credit accounts is the critical step towards taking control of your finances and positioning yourself for financial success. Make use of tools like principal and interest calculator apps and work out the cost of credit before you apply. Lastly, never take on debt that you can't afford, or if you don't understand the terms and conditions of the loan.
Use your international credit history to apply for U.S. credit cards
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