Finance

What does principal mean in finance?

Allison S Robinson | 20 July 2021 | 3 years ago

What does principal mean in finance?

In our ongoing bid to demystify finance and business for new entrepreneurs out there, we are adding this explanatory article on the term ‘principal’ and its meaning in finance to our vault of knowledge for you. It is a term used with that very powerful financial tool: credit.

Credit is powerful because it often takes an unmanageable amount and breaks it down into viable monthly payments. How does principal fit into that picture? We’ll use a personal loan as an example scenario.

What does principal mean in a personal loan?

A personal loan, unlike a study loan, home mortgage or vehicle finance, can be applied for to meet various needs, such as upskilling yourself, medical costs, or to strategically consolidate debt that is at a high interest rate.

Your personal loan contract will have a number of finance terms in it, one of which is ‘principal’. Here is a list of explanations:

Principal amount

This is the amount of money that you have been approved to borrow from the finance institution. If you were approved for an amount of £5,000, then that is the amount that will always be referred to as the principal amount – the amount that is given to you to spend. All the interest calculations made to work out repayments will be worked out on the outstanding principal amount.

Interest rate

This is the finance institutions “charge” to you for the benefit of using their money and for the risk they carry for loaning it to you. It is in a percentage format, and each month, they will multiply the principal amount by the interest percentage. They take the answer to that calculation and add it to a portion of the principal amount you are repaying, e.g. £25 (interest calculation) plus £85 (a portion of the principal amount you are repaying) = £105 payment in one specific month.

APR fee

This is the annual percentage rate the lender uses to show you the actual cost of your loan, including fees and interest rates. Comparing the APRs of various personal loan options is a good idea to choose the most affordable one.

Loan term

This is the number of months (years are expressed as 12 months) within which you have to fully repay the loan (capital, plus fees, plus interest). This is advised upfront during the approval phase.

Monthly repayment amount

This is the monthly payment amount from you to the lender. This will pay down (reduce) the principal of the amount, the interest and any fees.

Unsecured loan

This means the loan does not have any collateral against or 3rd party sureties put up for them. When you take out a home mortgage or vehicle finance, the asset (home or car) is the collateral. For a personal loan, the lender looks at your credit rating. If your credit rating does not meet their approval levels, then they might offer a secured loan, which means you will need to put up collateral or get a person with a good credit rating to sign on as surety for you.

Is the principal amount awarded linked to your credit rating?

There are several factors that a lender uses to calculate your eligibility for a loan. It is a good idea to be prepared for the loan application process before starting. This will help you avoid wasting time and, more importantly, allow you to make some changes that could help your rating.

Get a copy of your credit report, which will contain your credit score, so you can see what the lenders will be working with. Don’t be apprehensive about getting a copy of your own credit report; it doesn’t affect a lender’s assessment of the facts. The factors that the lenders will look at are weighted according to their importance to the lender. Below is an example list of weightings, but each lender may have their one weightings mix dependent on their risk appetite:

  1. Your payment history – how disciplined have you been in making payments regularly and on time. Example weighting: 35%
  2. The amounts owed – how much money do you currently owe to other lenders, and are you at the maximum you can possibly afford? This answer will affect the principal amount that could be awarded to you. Example weighting: 30%
  3. The length of your credit history – this is the amount of time, throughout your entire life, that you have carried and managed credit. This factor makes it tough for young entrepreneurs as everyone has to start their credit journey at some point. Your lack of credit history will be a disadvantage. Example weighting: 15%
  4. What new credit do you have – the lender will look at whether you have recently taken out a whole spate of loans around the market, which could mean you are in a spending frenzy and, therefore, high risk. Lenders have a very efficient network of information, so they will know your credit commitment. Example weighting: 10%
  5. What types of credits are you using – this is about the maturity of your credit profile, i.e. do you have a diverse mix of credit such as a mortgage, a credit card and a clothing store account. Example weighting: 10%
Once you have looked at the report, you might find that you need to take remedial action, which is to your advantage.

How to increase your chances of getting the principal amount you want

You have the power to get a good credit score if you plan ahead for a loan. Follow these guidelines for 12 months, and your credit rating will improve:

  1. Credit utilisation ratio – this means how much of your total are you using, i.e. is it always creaking at almost max? To improve this rating, keep your credit card balance/s at an amount that is below 15%–25% of the total credit balance available.
  2. Timely payments – if you have been tardy with payments, then now is the time to become punctual. Make sure you pay all your accounts on or before the due date. If you are going to be late with a payment, contact the creditor and notify them of the planned payment date. Plan that late payment to be within 30 days after the due date.
  3. New accounts – it is advisable to avoid opening a bunch of new accounts all at once. It might even be advisable to avoid opening a large quantity within a period of 12 months.
  4. Progress check – after 6 months, request a report and check on how your credit score is doing. It will be a good way to inspire you to keep going with your good habits.
As the negative behaviour and score goes deeper into your history, so will your current score improve.

A higher score will benefit you with lower interest rates and better loan terms. What can’t be avoided is your debt-to-income ratio (DTI). This compares how much you earn versus the total amount you have to pay back to creditors every month. You can work this out yourself by adding up the recurring monthly debt you have from credit cards, home loans etc. Take that amount and divide it by your gross monthly income. Gross income is the amount you earn before you deduct taxes or any monthly expenses. The answer will be a decimal value which you must change into a percentage amount, e.g. 0.36 = 36%. Creditors like a DTI to be under 36%, but you can still get a loan, but the principal amount may be restricted as well as the loan term.

Make informed credit decisions by checking your credit report and work out your DTI. You can then prepare for your credit application as well as develop better credit behaviour.

Topic

Finance

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