In the world of startups, finance terms are a core part of a founder’s vocabulary. If you don’t have a strong history in finance, accounting, or loans, though, it can be complicated to weed through conversations with banks or investors.
As a founder, it's imperative to know the difference between principal and interest, how to calculate each, and the different ways it affects the finances within your business. In this blog, we’ll walk you through the details of these two financial concepts.
What’s The Difference? Principal vs Interest
The word principal has a few different meanings in finance, depending on the context. For the purposes of this article, we’ll look at principal in terms of borrowing and investing money.
The most commonly used definition of principal is the total amount of money borrowed in reference to a loan or the amount placed into an investment.
The majority owner of a private company, a chief participant in a transaction, and the value of a bond are other lesser-used definitions of principal in finance.
Interest refers to the percentage charged to the borrower for borrowing money, in addition to the loan itself. This is commonly known as the annual percentage rate (APR). The financial institution or bank sets the interest percentage based on factors in the economy, — low demand in the Great Recession for example led to low interest rates — growth in gross domestic product, and inflation. The borrower’s credit scores also have an effect on interest rates, but if the demand is high, interest rates will remain high.
When borrowers meet or exceed minimum loan payments, the principal balance decreases. Borrowers owe less interest with every on-time or early payment. Once the borrower pays the interest off, payments will fully go towards paying down the remaining principal balance, if that is the type of payment plan you choose.
Simple Interest vs Compound
Simple interest and compound interest function in different ways. Simple interest — the most commonly used — means the percentage rate stays the same for the duration of the loan and only gets applied to the principal.
Compound interest applies to both the initial loan amount and accrued interest over time, thus increasing the amount the borrower owes. Look at it as interest on interest combined with the loan amount. Compound interest is beneficial when applied to savings or deposited income as it speeds up how quickly the money grows. If applied to a loan, the principal balance would increase if the borrower misses any payments.
Principal In Business Loans
According to a recent study, over 35% of startup businesses begin or grow their company with loans from accredited financial firms or banks. When you’re applying for a business loan, financial institutions will look at a variety of factors to determine the amount, interest rate, and overall eligibility.
Financial institutes will look at the following:
- Credit score
- Cash flow
- Personal wealth
- Personal money put towards the business
- Open credit lines
The number and amount of payments required toward the loan can differ depending on your financial institution. Take interest rates and the life of the loan into consideration before making a final decision.
How To Calculate Principal vs Interest
Calculating Simple Interest
Interest can add up if you don’t take a hard look at numbers and factor it into your loan budget. Thankfully, the formula for simple interest on business loans is pretty easy.
Let’s say you have a loan amount of $10,000 for office renovations at a 5% annual interest rate for three years. The total interest you would pay for the loan would be $1,500.
Loan x interest percent x loan length = Interest.
(10,000 x 0.5 x 3 = $1,500).
Loan + Interest = Total Paid
The total amount paid once the loan is complete comes to $11,500.
Finding a loan amount that will cover costs and remain in your budget is a key financial decision that you should not make hastily. You can calculate your monthly payment based on the loan amount, term, and assumed interest rate.
If you take a business loan out for $150,000 at a 5% interest rate over seven years, your monthly payment would be $892.
Loan amount x interest rate ÷ loan term (per month)
150,000 x .5 ÷ 84 months = $892
Types Of Loan Payments
Principal Payment Definition
A principal payment is any payment applied solely to the principal balance, not the interest. Payments towards loans go towards both the interest and principal, which can make the definition itself confusing.
In loan payments, a principal payment refers to the amount of money put towards the principal balance from each payment made.
Even Total Payments
This payment plan keeps your payment amount the same, but the amount applied to the interest will go down while the amount towards the principal payments goes up. If you have a loan for $20,000 with a 5% interest rate over 24-months your monthly payment equates to $417.
Every payment of $417 will be split and allotted to interest and principal balance until the loan is paid off.
Even Principal Payments
Using this payment structure, the same amount of money from your monthly payments will go towards the principal balance, while the amount towards interest will fluctuate. However, the monthly payment does not remain the same but decreases with each payment.
Interest is based upon the remaining lowered balance, decreasing the monthly payment while retaining the same amount given to the principal balance. Payments start high but gradually lower the longer time passes.
How Do You Know What Monthly Payment Your Business Can Afford?
At Zeni, we offer curated and detailed financial services for SaaS startups. Our financial advisors work hand-in-hand with our advanced AI-driven bookkeeping dashboard to keep all your finances on track. Whether you’ve already secured funding or a business loan or are just getting started, Zeni is here to make sure all of your financial records from cash flow projections to revenue reports are in order so that you can get the best financial backing possible for your startup.
Manage your financing with a clear, real-time accounting dashboard and help from the experts at Zeni. Book a demo to learn more.