What is a Principal?

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Definition:

The term principal has multiple meanings in finance, but most often it is the initial amount you take out in a loan.

🤔 Understanding a principal

The term principal has several different uses in the world of financial services. It refers most often to conversations of debt and investing. In the context of debt, the principal is the initial amount of a loan you take out. The principal applies only to the amount you receive from the lender — It doesn’t include interest. Loans such as mortgages aren’t the only debt instruments that have a principal — A bond also has a principal. It’s the initial value of the bond (meaning the amount the issuing entity is borrowing from investors). A principal could also refer to an investment — It’s the amount you initially put into an investment account. Alternately, a principal might refer to the owner of a private company or the main participant in a transaction.

Example

Let’s say that Elizabeth is preparing to buy a new car. She doesn’t have the cash on hand to purchase a vehicle outright, so she’s planning to take out a loan from her local credit union. Elizabeth decides to buy a car for $25,000, with a downpayment of $5,000. As a result, Elizabeth will be taking out a loan for $20,000 — This amount that she’s borrowing is the principal.

Takeaway

The principal is like the seed in a garden...

When you plant a garden, you start with seeds. The seeds will hopefully grow into different plants like vegetables and flowers. The seed is like the principal of a loan or investment. The plants that grow are like the earnings the principal earns. No matter how tall the plants grow, the principal always refers only to the seed you put in the ground.

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What is the principal of a mortgage?

Often the term principal is referring to a loan. When you take out a loan from a lending institution, the specific amount of money you borrow is the principal. Let’s say you take out a mortgage to buy a house. The price of the home is $225,000, and you have a downpayment of $25,000. Your total loan amount (your principal) is $200,000.

The principal could also refer to the amount you still owe of the initial amount you borrowed. So if you’ve paid off $50,000 of that $200,000 mortgage, your remaining principal is $150,000.

For other types of loans that may accrue interest, the principal does not include the interest that accrues on your loan, though you still have to pay it back too.

Suppose you just graduated from law school with a sizable amount of student debt. You’re on an income-based repayment plan, and for the first few years, your monthly payments are lower than the amount of interest accruing on your loan. The size of the debt you owe is increasing, but your principal remains the same.

What is an interest-only mortgage?

There’s another type of mortgage that works a bit differently — An interest-only mortgage. This type of mortgage, also known as a zero-principal mortgage is one where your monthly payments only cover the interest on the loan.

These interest-only mortgages come with smaller monthly payments since you’re not putting any money toward your principal. But they also prevent you from building equity in your home.

Eventually, though, you’ll have to pay back the money you borrowed. Most zero-principal loans stipulate a particular number of years, during which you only pay on the interest of your loan. After that time, you’ll start paying on the principal.

With this type of mortgage, the homeowner has a smaller monthly payment in the early years, and then the payment goes up when they have to start paying on the principal. These mortgages might be ideal for house flippers who know they’ll be selling the house during the initial period.

Zero-principal mortgages generally don’t prevent the homeowner from making payments on the principal. It merely gives them the ability to opt-out during a set number of years.

These loans might sound like a great deal, but they have major downsides. For one, the homeowner is not building equity in the home when they aren’t making payments on the principal.

Suppose that someone purchased a home when housing prices were high, and then paid only interest on their loan. When they go to sell their home, housing prices are significantly lower — So much so that they owe more on their mortgage than the house can sell for.

What is the principal of an investment?

When you open an investment account, you’ll make an initial deposit into your account. For some accounts, the company might require a particular amount to get started.

The amount you initially deposit to open your account is the principal. Let’s say you open an investment account and deposit $1,000. After seeing a 5% return, your investment account now has $1,050. You could choose to withdraw your $1,050, or you could reinvest it. In this case, your principal becomes $1,050.

This same principle applies to other investment products such as index funds, stocks, and mutual funds.

What is the principal of a bond?

When companies and governments need to raise capital, they’ll sometimes borrow the money they need. In some cases, they might borrow it from a bank or other lending institution. But they also might decide to issue bonds.

Bonds are investment products that are like loans — When a company issues a bond, they’re offering investors the opportunity to lend them money. In return, the issuing entity makes interest payments (aka coupon payments) to the bondholder during the life of the bond. The bondholder can sell the bond, and the issuing entity would make the interest payments to the new bondholder.

The face value (or par value) of the bond is the principal amount — this is the amount the bondholder should receive when the bond hits its maturity date. If a bond has a $5,000 face value, that is the principal. The principal of a bond does not include any money the bondholder receives for interest payments.

How does inflation affect the principal?

Inflation does not have a direct effect on the amount of your principal in regards to a loan, bond, or investment account. However, it does have an impact on the value of that amount.

In some cases, that can work in your favor. Suppose you took out a 30-year mortgage for $200,000. Over the next 10 years, imagine the United States saw an average inflation rate of 1.85% per year (which is consistent with what occurred between 2010 and 2019). The result is inflation has effectively reduced the principal every year by 1.85%, and the money you’re using to pay off the loan is less valuable than the money you borrowed.

Keep in mind that one reason lenders typically charge interest rates is to help offset potential losses due to inflation. Despite the value of your principal decreasing, the value of your home loan may still be growing — depending on other factors such as the terms of your mortgage.

Inflation could also work against you. Suppose that you invested $1,000 in the stock market. If your returns did not exceed the rate of inflation, then you would be losing money. If inflation increased by 1.85% per year from 2010 to 2019, then your investment would have had to see earnings of at least that much to stay even.

Who is the principal of a company?

When referring to a company, the term principal describes a particular person’s role. First, the term principal could refer to the owner of a company. This owner could be a founder and private equity owner, or it could be someone who owns part of a corporation due to stock they’ve purchased. Most often, the term refers to whoever owns the largest share of a company.

Instead of referring to the owner, the term principal could also refer to someone who has the authority to make critical decisions and transactions for the company. This person could still be the owner, or it could be someone they have designated to have this responsibility such as the chief executive officer (CEO) or a financial professional within the company.

The principal in a company is most often responsible for directing and overseeing the long-term vision of the company. They manage meaningful relationships with clients and stakeholders.

The principal also can make transactions on behalf of the company. In some cases, that might mean making a large purchase or taking on a loan. They also commonly make decisions regarding transactions such as mergers and acquisitions.

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