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

Principal is frequently the term used to refer to the original sum borrowed in a loan or put into an investment. The principal amount serves as the foundation for calculating interest, the returns on an investment, amortization schedules, and other parts of a transaction.

However, "principal" shifts meaning in other contexts: In bonds, it's the face value that will be returned to the bondholder when the bond matures, and in corporate and legal settings, it's the main actors in a company or the primary parties involved in financial transactions or legal contracts.

Whether you're taking out a mortgage, investing in bonds, or starting a business, the concept of principal is pivotal for understanding your costs and your potential financial returns.

Understanding the Principal of a Loan

When you borrow money for a car, a house, or education, the initial amount you borrow is called the "principal." This forms the basis upon which interest rates and repayment conditions are applied. Simply put, it's the money you actually get from the lender and need to repay, along with interest and fees, during the loan period. Over time, "principal" can also refer to the amount still owed on a loan.

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: As you make payments on your loan, a portion of each payment is applied towards reducing the principal. The remaining balance, known as the "outstanding principal," continues to accrue interest until the loan is fully paid off.

For example, let's say you take out a car loan with an initial principal of $20,000. After a year of making payments, your outstanding principal might be reduced to $16,000. 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 the interest rate and loan term remain constant. Therefore, understanding your principal amount is essential for understanding if a loan is within your budget.

How Interest Affects Principal

The amount of interest you pay on a loan is, therefore, determined by the principal amount. The larger the principal, the higher your interest payments, all else being equal. Depending on the loan terms, interest is either simple or compounded. Simple interest is only calculated on the original principal, while 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. For the second year, it would be the same. So, you'd end up repaying $100,000 (principal) + (2 x $5,000) (interest) = $110,000.
  
• For a compound-interest loan with the same initial terms, the interest for the first year remains $5,000. But for the second year, the interest would be calculated based on $105,000 (the initial principal + 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 with simple interest.

When you begin making monthly payments on a loan, much of the payment goes towards interest; the remainder is applied to your principal. As you continue paying the loan, more payments will be applied to the principal. 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. This means that the "real value" of the principal amount you borrowed may decline if you're repaying it over an extended period.

Imagine you borrowed $10,000 as a personal loan with a 10-year term. If the annual inflation rate is 3%, 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. So, while you're repaying the same "nominal" amount, the "real" value has declined due to inflation.

The Interplay Between Inflation and Interest

While inflation and interest rates interact with the principal amount of a loan, their combined effect can be quite different from just calculating one of these alone. Although you're paying more in nominal terms due to interest, 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 in an environment with positive inflation, the real cost of this interest may be lower than it initially appears.

Let's revisit the example of borrowing $10,000 for 10 years with a 3% annual inflation rate, but 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.
• However, 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

Beyond the principal for a loan, there are other key uses of the term "principal." In investing, the principal is the original amount of money invested, separate from any earnings or interest accrued.

For example, assume you deposit $5,000 in a high-interest-bearing savings account, bond, or CD. If the interest rate was 4.5%, at the end of 10 years, your account balance would have grown to $7,765.00. The $5,000 you initially deposited is your principal, while 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, back when bonds were actual physical pieces of paper, this amount was printed on the face of the bond itself).

The bond's principal excludes any coupon, recurring interest payments, or accrued interest (although the issuer is obligated to pay these as well). For instance, 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, except when it is first issued, is not necessarily the same as its market price. Depending on the state of the bond market, a bond may be purchased for more or less than its principal.

Principal in Ownership

The owner of a private company, partnership, or other firm type is also called a “principal.” This is not necessarily the same as a CEO. A principal could be an officer, a shareholder, a board member, or even a key sales employee. Basically, it’s the primary investor or the person who owns the largest share of the business.

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 to 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 takes on the attendant risk. A principal can be an individual, a corporation, a partnership, a government agency, or a nonprofit organization. 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. In those documents, the principal is everyone who signed the agreement and thus has rights, duties, and obligations for the transaction.

A person who hires a financial advisor is considered a principal, while the advisor is the agent. The agent follows the instructions given by the principal and may act on their behalf within specified conditions. While 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. If the agent makes a bad investment, the principal is the one who takes the loss.

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. Whether you're borrowing money or looking to grow your nest egg through investments, a firm grasp on the idea of principal is vital for your financial well-being.

The term "principal" also refers to the amount you contribute to an investment, an amount loaned to you, or the face value of a bond. It is also used for someone who owns the majority of the shares of a company or the person in a relationship who ultimately retains the risk for financial transactions.