Definition: A principal payment is a disbursement that is directly amortized to the principal owed on a given loan. Simply put, it is a payment that reduces the outstanding debt.
What Does Principal Payment Mean?
What is the definition of principal payment? A principal payment can be made in different situations. An individual or corporation paying the minimum payment set for any loan is making a principal payment, since the minimum payment has a portion of interest and another portion of principal. On the other hand, a borrower might decide to pay a loan in advance, before the loan is due, in this case the individual is making a full principal payment to get rid of the loan.
Another scenario would be an anticipated partial principal payment. The purpose of this transaction is to reduce the debt, to shrink the interest expense. In all of these cases, there might be a penalty fee involved for the anticipated amortizations. The first payments made to any loan are mostly interest expense; as the loan periods continue to move forward the payment gradually moves to have a bigger portion of principal being amortized.
Here’s an example of this concept.
Example
Party Vehicles Co. is a car rental company located in Miami. The company main business is to lease sports vehicles to tourists visiting the city. The company has a 20 car’s fleet and due to the high demand it wants to expand the business by buying new cars to add to its fleet. The company asked for a $300,000 loan for this project. After a few months, the company owes $230,000 of principal and given that they found an investor to fund this expansion they want to reduce the loan by paying $150,000 to the principal owed by using the funds obtained from the new issued shares. Is this possible?
Yes, according to our concept of principal payment, the company can ask its bank to accept an anticipated payment of $150,000, this will leave the company with a current principal balance of $80,000. This new scenario will reduce the interest expense of the company, increasing its profitability.
Summary Definition
Define Principal Payments: PP means a loan payment that reduces the balance of the loan.
