Principal Balance: What It Is and How It Affects Your Mortgage

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:

1. Interest rate: Principal balances decrease faster as mortgage rates drop.
2. Loan term: Principal balances decrease more quickly with shorter loan terms.
3. 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.