Definition
Principal refers to the original sum of money borrowed in a loan or set in an investment. In a loan, it is the initial amount that the debtor is obligated to pay back to the lender. In an investment, it represents the original sum that has growth potential through interest and capital gains.
Phonetic
The phonetics of the word “Principal” is /ˈprɪn.sə.pəl/.
Key Takeaways
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- Principal is the base amount of money on which interest is calculated in any credit deal or investment.
- It can also refer to the original amount of investment, or the remaining balance excluding interest.
- Repaying the principal of a loan before the due date can reduce the total amount of interest paid.
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Importance
The term “Principal” is essential in business and finance as it represents the initial amount of money that was borrowed or invested, separate from interest or returns. Understanding the principal amount is crucial because it forms the basis for calculating interest, potential returns, or penalties on loans or investments. It sets the foundation for managing debt repayment structures or investment growth. The changes to the principal, whether through repayment in the case of loans or reinvestment in the case of investments, significantly impact the overall financial outcome. Thus, managing and understanding the notion of principal is fundamental in business and finance operations.
Explanation
The principal amount is a fundamental component in finance and plays a pivotal role in various transactions and financial instruments. The principal serves as the primary source or the original amount of money that is either borrowed, invested or saved, upon which interest or profits are calculated. For instance, if you take a loan, the principal represents the amount you initially borrow, and it is the figure from which your interest payments will be computed. Moreover, when investing, it refers to the initial amount of money put up as an investment, providing the base from which profits or losses are subsequently generated.In a savings account, the principal is the amount of money initially deposited, which will then accumulate interest over time based on the stipulated interest rate. Similarly, in bonds, the principal denotes the face value of the bond that the issuer pays to the bondholder at maturity. It essentially forms the groundwork of any financial arrangement and serves as a reference point upon which subsequent financial computations, be it returns on investment, interest, profit, or loss, are derived. Understanding your principal amount proves essential in managing your finances, planning your future payments, and assessing your overall financial standing.
Examples
1. Mortgage Loans: When someone buys a home using a mortgage loan, the amount borrowed to purchase the property is called the principal. Over time, the homeowner will pay back this principal along with interest to the lender. If the loan was for $200,000 for instance, that’s the principal amount.2. Savings Accounts: If a person deposits $1,000 into a savings account, that initial amount is considered the principal. Over time, the bank pays interest on this principal amount, and the wealth accumulates depending on the interest rate and time. 3. Bonds: When a company or government issues a bond, the face value of the bond is the principal. If a company issues a $10,000 bond, for example, that means the company owes $10,000 to the bondholder. At some agreed-upon future date, the company will repay this principal amount to the bondholder.
Frequently Asked Questions(FAQ)
What is principal in finance or business term?
The principal in finance or business term refers to the original sum of money borrowed in a loan, or put into an investment, which is distinct from the interest that accumulates on it.
How does principal differ from interest?
Principal refers to the initial sum of money borrowed or invested, whereas interest is the fee charged by the lender to the borrower for the privilege of borrowing that money.
Does the principal amount change over time?
In most cases, the principal amount does not change unless the borrower makes payments towards the principal, which reduces it, or takes out additional funds against it, which increases it.
How is the principal payment calculated in an installment loan?
In an installment loan, each payment is split into two parts: a portion that goes towards repaying the principal and a portion that covers the interest. The exact amount that goes towards the principal and interest varies from payment to payment, however, the total amount of each payment is usually the same.
What happens when the principal is paid off?
Once the principal is paid off, the borrower no longer owes any money to the lender unless the terms of the loan included other fees or expenses.
Is investing principal at risk?
Yes, when you invest, your principal is at risk. If your investment loses value, you could lose some or all of your principal.
Is principal impacted by inflation?
Yes, inflation can erode the value of your principal. For example, if inflation is high, the purchasing power of your principal will decline. That’s why many investors prefer investments that can potentially outpace inflation.
Related Finance Terms
- Interest
- Debt
- Loan
- Amortization
- Investment
Sources for More Information
