What is a principal payment?
The portion of a loan payment that reduces the balance owed. Interest is a separate piece of the same check.
Definition
A principal payment is the part of a loan installment that reduces what you still owe. On the books, this is a drop in the liability, not an expense.
The rest of the same check is usually interest. Interest hits the P&L; this piece only pays down the note.
Cash-basis and accrual books both drop the loan when principal is paid. The cash left the bank either way.
This is remaining principal going down. It is not a cost of doing business on the Income Statement.
Where it shows up
Balance Sheet: Related to reducing the remaining loan balance.
P&L: Related to interest on the same installment.
Cash flow: Decreases in the loan, reported cash from financing activities decreases.
See also: Loan Amortization Schedule · Notes Payable · Cash Flow From Financing
When you look at your Balance Sheet, this payment is why Notes Payable, or the Current Portion Of Long-Term Debt, is lower than last period. You will not find a line named for the payment itself.
The profit and loss statement does not take the principal piece. Interest on the same installment is the related P&L charge.
On the Statement of Cash Flows, paying principal is a financing outflow. The loan falls, and reported cash from financing activities falls with it.
A large principal piece in a period usually means the note is older, or you sent extra money to the lender. A small principal piece usually means the installment is still heavy on interest.
How it works
You read the Loan Amortization Schedule to see how much of this installment is principal. You debit Notes Payable, or the current slice of that note, and you credit cash.
The Debt Schedule should then show a lower remaining balance. Total amounts owed fall by the principal piece only.
Interest is recorded on its own. Mixing the two into one expense account will overstate costs and leave the loan too high.
If the next twelve months of principal already sit in Current Portion Of Long-Term Debt, the pay-down hits that current line. The longer-term remainder does not move until the next reclass.
New borrowing is the opposite event. Cash in raises the note; this payment is cash out that lowers it.
When the note is paid off, the last principal piece should bring that loan to zero. An old balance that still appears usually means a payment was posted to interest, or to the wrong account.
Keep the split from the schedule, not from a guess. Anyone picking up the file later should see why this check dropped the note by the number it did.
Example
A quilt shop pays $1,000 on a sewing-machine note. The Loan Amortization Schedule says $800 is principal and $200 is interest.
The shop records the principal piece:
Debit: Notes payable $800
Credit: Cash $800
Notes Payable falls by $800, and cash falls by $800. The Income Statement has not taken an $800 expense.
The $200 interest piece is recorded on its own. That charge is the only part of the $1,000 check that belongs on the P&L.
The Debt Schedule now shows $800 less remaining on that row. Next month's installment will split again, usually with a slightly larger principal piece.
Common mix-ups
A principal payment is not an expense. Interest is the cost of using the money; this piece only reduces the remaining loan.
A principal payment is not the whole check. The same installment usually includes interest, and those two pieces hit different statements.
A principal payment is not new borrowing. Cash already came in when the note was booked; this is cash leaving to pay that note down.
Related terms
- Loan Amortization Schedule: The payment-by-payment breakdown of a loan into principal and interest.
- Interest Expense: The cost of borrowing recorded for the period.
- Notes Payable: Formal loan balances owed to a bank or other lender.
- Cash Flow From Financing: Cash from borrowing, repayment, owner contributions, and distributions.
- Debt Schedule: A supporting schedule tracking each loan's balance, payments, rate, and maturity.
- Current Portion Of Long-Term Debt: The slice of loan principal due within the next twelve months.
- Free Cash Flow: Operating cash flow left after the capital spending needed to keep running.
- Debt Service Coverage Ratio: Cash available to cover scheduled principal and interest payments.