Principal: Definition in Loans, Bonds, Investments, and Transactions

What Is Principal?

Principal is the original sum of money that's borrowed in a loan or placed into an investment. The term translates to "first in importance" in Latin and a loan or investment begins with this amount. Principal serves as the foundation for calculating interest on a loan or for the returns on an investment. Amortization schedules and other components of a transaction also rely on principal. It's also the face value of a bond that will be returned to the bondholder when the bond matures.

Principal also refers to the leader of a company or the primary parties involved in legal contracts. The concept of principal is pivotal for understanding your costs and your potential financial returns whether you're taking out a mortgage, investing in bonds, or starting a business.

Understanding the Principal of a Loan

The initial amount you borrow when you accept money to purchase a car, a house, or education is referred to as the principal. It forms the basis upon which interest rates and repayment conditions are applied. It's the money you receive from the lender and must repay during the loan period along with interest and fees. Principal can also refer to the amount still owed on a loan over time.

There are essentially two kinds of principal balances in the context of loans:

1. Initial Principal: This is the original amount borrowed from the lender. It serves as the baseline for calculating interest and determining the repayment schedule.
2. Outstanding Principal: A portion of each payment is applied toward reducing the principal as you make payments on your loan. The remaining balance is referred to as the outstanding principal and it continues to accrue interest until the loan is fully paid off.

Let's say you take out a car loan with an initial principal balance of $20,000. Your outstanding principal might be reduced to $16,000 after a year of making payments. The interest for future payments is calculated based on this new outstanding principal.

The size of the principal amount is directly proportional to the overall cost of the loan. A higher principal will result in higher interest payments over the life of the loan, assuming that the interest rate and loan term remain constant.

How Interest Affects Principal

The amount of interest you pay on a loan is determined by the principal amount. The larger the principal, the higher your interest payments will be.

Interest is either simple or compounded, depending on the loan terms. Simple interest is calculated on only the original principal. Compound interest is calculated on the principal and any accumulated interest.

• Suppose you borrow $100,000 at a simple interest rate of 5% per year for two years. The interest for the first year would be $100,000 x 0.05 = $5,000. It would be the same for the second year. You'd end up repaying $100,000 in principal + 2 x $5,000 in interest for a total of $110,000.
  
• The interest for the first year remains at $5,000 with a compound interest loan with the same initial terms. The interest would be calculated based on $105,000 in the second year: the initial principal plus the first year's interest which would be $100,500 x 0.05 = $5,250. You'd repay $105,00 + $5,250 = $110,250, or $250 more than you would have with simple interest.

Much of the payment goes towards interest when you begin making monthly payments on a loan. The remainder is applied to your principal. More payments will be applied to the principal as you continue paying the loan. Paying down the principal of a loan can reduce the amount of interest that accrues each month.

How Inflation Affects Principal

Inflation effectively decreases the purchasing power of money over time. The real value of the principal amount you borrowed may decline if you're repaying it over an extended period.

Suppose you borrowed $10,000 as a personal loan with a 10-year term. The value of that $10,000 would only be equivalent to about $10,000 / (1 + 0.03)¹⁰ or $7,441.58 at the end of the loan term if the annual inflation rate is 3%. You're repaying the same nominal amount but the real value has declined due to inflation.

The Interplay Between Inflation and Interest

Inflation and interest rates both interact with the principal amount of a loan but their combined effect can be quite different from the result of just calculating one of these alone. You're paying more in nominal terms due to interest but the real burden of your debt could be less severe when you factor in inflation. Here's how:

1. Erosion of Debt Burden: Inflation reduces the real value of the money you owe, making it cheaper to repay the loan in the future.
2. Interest Costs: The interest rate adds to your debt burden but the real cost of this interest may be lower than it initially appears in an environment with positive inflation.

Let's revisit the example of borrowing $10,000 for 10 years with a 3% annual inflation rate. Now note that the loan was taken out with 5% simple interest. Assume both rates remain constant over the term of the loan.

• The nominal amount to be repaid would be $15,000 due to interest.
• The real value of that $15,000 at the end of 10 years, adjusted for 3% annual inflation, would be approximately $15,000 / (1 + 0.03)¹⁰ = $11,162.37.
  

Principal in Investing

Principal is also the original amount of money you've invested, separate from any earnings or interest accrued.

Assume you deposit $5,000 in a high-interest savings account, bond, or CD. Your account balance would have grown to $7,765.00 at the end of 10 years if the interest rate was 4.5%. The $5,000 you initially deposited is your principal. The remaining $2,765.00 is attributed to earnings.

Principal in Bonds

The principal of a bond or other fixed-income investment is the amount the issuer agrees to pay back to the investor upon the bond's maturity. A bond's principal is also known as its par value or face amount because this amount was printed on the face of the bond itself back when bonds were issued on actual pieces of paper.

The bond's principal excludes any coupon, recurring interest payments, or accrued interest although the issuer is obligated to pay these as well. A 10-year bond with a $10,000 face value may be issued and have $50 recurring coupon payments semiannually. The principal is $10,000, independent of the $1,000 worth of coupon payments over the bond's life.

A bond's principal isn't necessarily the same as its market price except when it's first issued. A bond may be purchased for more or less than its principal depending on the state of the bond market.

Principal in Ownership

The owner of a private company, partnership, or other firm type is also referred to as a principal. This isn't necessarily the same as a CEO. A principal might be an officer, a shareholder, a board member, or even a key sales employee.

A company may also have several principals with the same equity stake in the firm. Anyone considering investing in a private venture will want to know who its principals are so they can assess the business’s creditworthiness and potential for growth.

Principals As Responsible Parties

The term principal also refers to the party who can transact on behalf of an organization or account and who takes on the attendant risk. A principal can be an individual, a corporation, a partnership, a government agency, or a nonprofit organization in this case. Principals may elect to appoint agents to operate on their behalf.

A principal could be involved in transactions ranging from a corporate acquisition to a mortgage. The principals are usually listed in the transaction’s legal documents. They include everyone who signed the agreement and who therefore has rights, duties, and obligations for the transaction.

An individual who hires a financial advisor is considered to be a principal. The advisor is the agent. The agent follows the instructions given by the principal and may act on their behalf under specified conditions and terms. The advisor is often bound by fiduciary duty to act in the principal’s best interests. The principal is at risk for any action or inaction on the agent's part. The principal takes the loss if the agent makes a bad investment.

The Bottom Line

The concept of principal serves as a key term for understanding financial products like loans, bonds, and investments. Knowing how principal interacts with interest, inflation, and returns can empower you to make more informed financial decisions. A firm grasp of the idea of principal is vital for your financial well-being whether you're borrowing money or looking to grow your nest egg through investments.