What is a Loan Principal?
Definition: A principal is the amount of money a person or a company borrows from a lender. It is also the amount of money, which a borrower agrees to pay a lender minus interest. Principal can also refer to the amount of loan remaining after making some payments.
The principal sum of a loan determines the amount of interest that one will end up paying in the end. For instance, a loan of $2,000 at an annual interest of 10% will accrue interest of $200 every year. Similarly, a $500 loan with an interest of 10% will accrue an interest of $50 every year.
Any amount repaid after every month to settle a loan normally goes towards settling the accrued interest at first. Any remaining amount will consequently be used to settle the principal amount. To ensure that the amount of money owed declines significantly, it is important to ensure that a good chunk of the repayment amount goes towards settling the principal amount. This is because the principal determines the amount of interest payable.
A zero principal mortgage is a special type of financing used to settle the principal borrowed. In this type of financing, any amount of money made goes towards settling the interest accrued. The result is that the principal amount remains the same, which means there is no development made in settling the debt.
However, zero principal mortgages can come in handy in some situations as well. Consider a borrower who is just getting started in their career. In this case, one can opt to take a zero principal mortgage and pay interest only in anticipation that salary will increase in the future. When the income increases, he or she will be able to settle the principal loan amount with ease with zero accumulation of interest.
Types of Principal
Principal in Investments
Principal can also be used to denote the original amount of investment that an investor makes devoid of earnings or interest accrued. Consider a person who deposits $1,000 in an interest-bearing account. After ten years the account balance might have grown to $2,700. In this case, the principal amount in the final figure would remain $2,000 while the extra $700 would amount to return on invested capital.
Principal in Bond Matters
When it comes to debt instruments, principal is a commonly used term. For instance, principal is used to denote the face value of a bond, which is the actual amount of the listed bond. It can also refer to the sum that the bond issuer owes the bondholder at maturity. In the case, the bond value would exclude any recurring interest payments or coupons.
Consider a ten-year bond with a $20,000 face value and a $50 recurring coupon payment semiannually. In this case, the bond principal amount is $20,000.
Principal in Private Companies
An owner of a private company is often called a principal. While different from CEO, the principal could be a majority shareholder, officer, or board member. Likewise, a company might have several principals all of whom have equal equity in the company.
Factors that Affect Principal Example
Inflation
Inflation is one of the factors that affect principal amount in most cases. However, it is important to note that the nominal value of any principal value is not affected by inflation. Instead, it only erodes the principal’s real value.
Assume a $10,000 ten-year treasury bond. If the 10-year average annual inflation rate is 4%, the real value of the bond after ten years will be $6,755. What this means is that the value of the $10,000 bond has decreased to only $6,755 due to high inflation. However, its nominal value remains $10,000.