How Loan Balances Work

Loans are simple in theory but are often made quite complex by lenders. All that fine print and “legalese” turns something that should be a basic contract between two parties into something totally different. It’s important to learn a few terms that will make understanding your loan a whole lot easier.

Loan Balance Basics: Principal & Interest 

For all loans, no matter who they’re from or what they’re for, principal and interest are going to be the two main driving forces determining how much you need to pay. Let’s break down these two concepts a bit more so you can better understand why they’re so important to “getting” how your loan works:

  • Principal is the amount of money you’re borrowing up front. When you take out a loan for X amount of money, X is the principal. It’s important to conceptualize a few things about principal, namely: Are you realistically going to be able to pay off this loan in the given timeframe based on your current circumstances? You don’t want to be taking out a loan above your paygrade on the assumption you’ll be making more down the line.
  • Interest is how lenders make a profit from loaning money. Without interest, they would just be giving you money for no reason. It’s important you understand how the interest rate on your loan is going to affect the amount you end up paying on it. Higher interest rates can lead to loans lasting for far longer than people anticipated. These higher rates are most common with credit cards, as there’s typically no hard asset for the lender to take back if you don’t pay and therefore more risk for lenders.

Certain loans have you servicing the interest alone for a certain period of time; others, called amortizing loans, split your payments between principal and interest each month.

Principal and interest work together to determine how much you end up paying over the life of the loan. If it’s a mortgage, you can probably get a pretty accurate picture of this, since payments are consistent. With credit cards, however, the amount you’re going to pay in total can be a lot more ambiguous. This is where it’s important to learn about capitalization on a loan.

Some people incorrectly assume that interest payments only derive from the original principal on a loan. This is, unfortunately, not the case. The reality is that interest typically accrues onto your principal, which can then in turn start earning interest. This is why people can get into so much trouble when their credit card accounts start to balloon.

Dealing with Credit Card & Loan Debt

One option for dealing with debt is credit card debt consolidation, which entails taking out a loan to pay off other high-interest debts then repaying that single loan in fixed installments over time. In order to make sure this course of action is financially advantageous, you’ll need to calculate how much you’ll pay in principal and interest over the loan’s entire term.

Some borrowers may not be able to qualify for a debt consolidation loan based on their credit history. So, it’s worth exploring other options before bankruptcy — including settlement and management.

There are a couple important things to note about debt relief and debt management services. First of all, consumers need to do a bit of independent research before signing up with a debt relief service. When something sounds too good to be true, it probably is. Some seemingly legitimate services actually take advantage of people when they’re most vulnerable. It’s not a bad idea to start out by talking to a free credit counselling service to see what advice they can give you.  

Loans are simple instruments that are made complex by our modern world. Learning the basics of how loans work can vastly simplify your life.