Definition: The outstanding balance that remains on a loan. If a loan is only being considered between a borrower and a lender, then it is the amount to be borrowed.
Example: Timothy borrows $10,000 from a bank. The annual interest rate is 6%. He will pay back the loan over five years, making only one payment at the end of each year. He is given the following payment schedule by the bank:
| Year | Payment | Principal | Interest | Balance |
|---|---|---|---|---|
| 1 | $2,373.96 | $1,773.96 | $600.00 | $8,226.04 |
| 2 | $2,373.96 | $1,880.40 | $493.56 | $6,345.63 |
| 3 | $2,373.96 | $1,993.23 | $380.74 | $4,352.41 |
| 4 | $2,373.96 | $2,112.82 | $261.14 | $2,239.59 |
| 5 | $2,373.96 | $2,239.59 | $134.38 | $0.00 |
| Total | $11,869.82 |
This is known as an Amortization Table. It shows how much of each $2,373.96 is payment of interest on the loan principal and how much of the payment is going towards reducing the amount of the loan principal. If you check, on each line you will see that the sum of the Principal and Interest columns in the table equal the amount shown in the Payment column.
Investeach explains: The above loan is known as a “term” loan. The borrower pays a set number of equal payments at equal intervals over a specific number of periods. Here, each payment is in the amount of $2,373.96 made one year apart for five years.
Riddle me this:
1. What type of loan is usually used to pay off a loan?
2. Why is it that when a payment is made, not all of it is applied to the principal?
3. What is another name for the table a lender will provide showing how each payment breaks down between principal and interest?
Credits: Steve Kong contributed to this definition.