Key Takeaways
- Principal balance is the remaining amount you owe on your mortgage.
- Extra payments can reduce your principal balance faster.
- Principal balance affects when you can remove PMI from your loan.
- Lower interest rates help decrease your principal balance more quickly.
Article Summary
Principal balance is the amount of unpaid money on a mortgage loan.
Principal Balance: Explained in Plain English
In mortgage terms, principal balance is the amount of money owed on a mortgage.
At the start of the mortgage, the principal balance, sometimes called a loan balance, is the original loan amount. As the mortgage holder makes on-time payments each month, the principal balance reduces until the loan is paid off and the home is owned free and clear.
The rate at which a mortgage's principal balance decreases is based on 3 factors:
- Interest rate: Principal balances decrease faster as mortgage rates drop.
- Loan term: Principal balances decrease more quickly with shorter loan terms.
- Loan type: Principal balances decrease faster with loans that amortize compared to loans that do not amortize, such as home equity lines of credit.
Loan balances can also be reduced more quickly when homeowners make extra principal payments as part of their regular monthly payments.
Principal Balance: A Real World Example
Imagine a first-time home buyer purchasing a home and using a 3% down Freddie Mac Home Possible mortgage to finance it.
Because the home buyer opted for a low-downpayment mortgage, the lender requires private mortgage insurance (PMI) until the mortgage balance falls to 80% of the home's value, which the home buyer estimates will take four years to happen.
In the first few years of the mortgage, due to amortization schedules, the buyer's monthly payments primarily pay for interest and only marginally reduce the principal balance.
However, the housing market has been strong during these few years, and the home's value has risen. By paying down the loan and gaining equity through appreciation, the buyer's loan balance drops to 80% of the property's value. As a result, the lender removes its private mortgage insurance requirement.
Common Questions About Loan Balance
Get answers to frequently asked questions about principal balance, including how it decreases over time and the impact of extra payments.
Why does my loan balance decrease slowly at the beginning of my mortgage?
The initial slow decrease in a loan balance is due to its amortization schedule, where early payments are predominantly applied towards interest rather than principal. With each subsequent payment, a greater portion is applied to the principal, and a lesser portion to interest.
Can I pay off my loan balance early?
Yes, you can pay off your loan balance early. This can be done by making larger or additional payments towards the principal. Extra principal payments can be one-time, monthly, or sporadic.
How is my loan balance affected in a refinance?
Refinancing a loan is when a homeowner pays off their existing mortgage and replaces it with a new one, often with different terms or interest rates. The former loan balance is paid off in full. The new loan balance will depend on how the refinance is structured. Loan balance may increase, decrease, or stay the same.
Does making extra payments towards my loan balance make a difference?
Making extra payments towards your loan balance reduces the interest you pay over the life of the loan and can lead to an earlier payoff. Extra payments are applied directly to the principal, reducing the balance and the interest calculated on it.
