The word principal is tossed around quite a bit in the finance world. However, depending on the application or sector, principal can have a completely different meaning. From investments, to mortgages, you can’t avoid this word. Let’s explore this term in greater detail below.
How Does Principal Work?
Principal works in a variety of different ways. If you were to borrow money, or take out a loan, principal is the amount of money you must repay the lender. If you are an investor, the principal balance is how much money you invested in a particular investment.
How Is Principal Used?
Depending on the platform, principal has a variety of uses. The most common uses are:
Principals in Loans
The principal balance on a loan is how much money you actually borrowed from a lender. You’ll see your principal balance on various types of loans, including; mortgages, car loans, student loans, and personal loans.
Let’s take a closer look at mortgages.
If you wanted to buy a house that’s $300,000 and were planning on putting $60,000 down as a down payment, you’d need to borrow $240,000 from a lender to finance the outstanding balance on the home. That $240,000 is the principal loan balance. There are a variety of mortgage options you can choose from, but let’s assume you chose a standard 30-year fixed rate mortgage for this example.
You’ll be responsible for paying the principal balance off for the next 30 years, and banks will of course charge an interest rate on the borrowed money. Each month when you pay your mortgage, a portion of your money will be spent on paying the interest, and a portion of the money will be spent paying down the principal balance.
Principals in Investing
In the world of investing, the principal balance is how cash the investor actually invested. This is true for stock investments, real estate investments, mutual fund investments, or even investing directly into a business.
For example, if someone were to invest $100,000 into a stock, that $100,000 is their principal balance. If the stock appreciated 5%, or $5,000, their principal investment is still $100,000. Anything over is the profit, and anything less is the loss.
Principals in Bonds
The bonds principal is also referred to as the face value of the bond. This is the amount of money the issuer promises to pay back to the lender upon the bonds expiration date.
For example, if an investor were to buy a bond that pays a 3% interest rate for 5 years, the investor would receive the interest payments each year for the next 5 years. Once the bond has fully matured, or 5 years has elapsed, the principal balance is returned back to the investor.
Principals in Private Companies
To further add to the multiple definitions principal has, some companies refer to the owner or the executive team as the principal(s).
What Is the Difference From the Principal and Interest?
Remember, principal is the actual amount of money you borrowed or invested.
Similar to principal, interest has a few different meanings as well.
When someone is talking about the interest of an investment, they are referencing how much money their investment makes. For example, if you earn a 5% interest rate on a $100,000 investment, you earned $5,000 in interest.
Whereas in the loan world, interest is how much money someone pays a lender for borrowing the lenders money. If one were to borrow $50,000 for a personal loan, and the bank charged a 3% interest rate for borrowing that money, the borrower must repay the principal balance ($50,000) plus the interest ($1,500).
Interest Comes in All Shapes and Sizes
There is not a one size fits all definition for interest. Various loans and investments have a variety of interest options.
- Fixed Rate: A fixed rate loan means the interest rate does not change for the duration of the loan.
- Adjustable Rate: Quite opposite to the fixed rate loan, an adjustable rate loan simply means the interest rate can adjust over time. The adjustment can move in either direction, either up or down.
- Compounding Interest: Compounding interest is when your interest earns interest.
However, compounding interest is not always a good thing. Credit card companies tend to charge compounding interest on the outstanding credit card balance, which is why credit card debt can be so paralyzing for millions of Americans. The interest just continuously adds up!
What Affects the Principal?
Inflation can have a big impact on the principal balances. In particular, the risk of inflation is evident in bonds and various investments.
When you buy a bond, you receive interest payments for a specific period of time. Once the bond matures, you get your full principal balance back. However, if inflation occurred throughout that period, the $1,000 you initially invested in year 1 does not have the same purchasing power in year 5. The bank will still give you back $1,000, but its purchasing power may be equivalent to present day $900.
The same concept is applied to the world of investing. If your principal balance is tied up in an investment, and the investment is not earning more than inflation, your investment is losing purchasing power over time. This is a common problem with traditional checking and savings accounts, which is why people look to invest their money in investments that earn a greater rate of return – above and beyond inflation.
In the Know
Considering how often the term principal is tossed around in the financial world, it’s a good idea to have an understanding of what it actually means. Keep in mind, there are numerous definitions for this term depending on the context.
- In the loan world, it is referring to how much money the borrower borrowed from a lender.
- When it is discussed in the investing world, it is referring to the amount of money an investor put into a specific investment.
- Last but not least, some companies refer to the executive team, or the owner, as principal members.
The finance world is filled with words that have numerous meanings. Principal is just one of them! Navigating through these waters can feel overwhelming, especially when the same word can mean something completely different depending on the platform. Working with a financial advisor can help make sense of all the noise and can help you and your family reach your financial goals!