Principal balance is the amount of unpaid money on a mortgage loan.
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A Longer Definition: Principal Balance
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 starting loan size. 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 standard rate at which a mortgage’s principal balance reduces is based on 3 factors:
- Interest rate: Principal balances reduce at faster rates as mortgage rates drop
- Loan term: Principal balances reduce faster with shorter loan terms
- Loan type: Principal balances reduce faster with loans that amortize loans that do not amortize such as home equity line of credits
Loan balances can also be reduced more quickly when homeowners send extra principal to their lender as part of their regular monthly payments.
Principal Balance: A Real World Example
First-Time Home Buyer Stories: Principal Balance
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, their 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, because of amortization schedules, the buyer’s monthly payments mainly 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 getting equity appreciation, the buyer’s loan balance drops to 80% of the property’s value, and the lender removes its private mortgage insurance requirement.
Common Questions About Loan Balance
Why does my loan balance decrease slowly in the beginning of my mortgage?
The initial slow decrease in a loan balance is from its amortization schedule, where early payments are predominantly applied towards interest rather than principal. With each subsequent payment, a greater portion is allocated to the principal and a lesser portion to the interest.
Can I pay off my loan balance early?
Yes, you can pay off your loan balance early. This is typically 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, reduce, or stay as-is.
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.
