Principal is the amount of money you’re borrowing from a lender or financial institution, before any interest or fees.
What Is Principal?
In finance, principal refers to the amount of money that a person borrows from a bank, a credit union, or other financial institution. It does not include any additional sums that are included in the overall amount of money a person needs to pay back, such as interest and fees.
For example, if you are planning to buy a motorcycle, you borrow $10,000 from a bank or other lender. This amount of money is principal. After you have started repaying it you will notice that the principal balance on your loan account has gone down.
However, the principal can also designate an amount of money that you invest in something or the face value of a bond.
What Are Profit and Interest?
In banking, we use the term principal to distinguish it from profit and interest.
Profit
If you are investing an amount of money to earn more in the future, we discuss that additional earning in terms of “profit.”
For example, if you decide to put $2,000 into your savings account where you will be able to accumulate interest over the years, your balance may be $3,000 at some point. This means you have $1,000 of profit in that account, while the $2,000 is the principal. The extra $1,000 came from your account earning interest while it sat in the bank.
Profit can also refer to the money that a financial institution earns by lending you money. From your point of view, as a borrower, that is interest, but it does not benefit you as the borrower.
Interest
Apart from the principal, or the amount you originally agreed to borrow from your lender, you will also likely need to pay the interest on the loan. This is, simply put, how much the act of borrowing the money costs. This additional amount of money depends on the lender, the repayment period, and the amount of money you are borrowing. It can also vary based on other factors, including your credit score, your financial history, your income, and other various personal information.
We express interest as a percentage. For example, you can borrow money from a lender at 10% interest. This means that it will cost you 10% of the total principal to borrow the money per year. If your financial situation allows you to pay higher principal payments, your interest rate will be lower because the principal is reduced over time.
If you want to know how much you will pay for the interest each month, you can easily calculate it. Multiply the interest rate your lender gave you by the outstanding loan balance and then divide this number by 12. The next month, after you pay your next installment and the outstanding balance is lower, you still calculate the interest the same way. The interest payment will be lower because of the lower principal.
Fixed vs. Variable Interest Rate
When you take out a loan with a fixed interest rate, that means that the interest percentage does not change throughout the time period you have to pay off the loan. You and your lender establish a repayment schedule at the beginning of the loan so your (monthly) installments stay the same, and you always know how much you need to pay.
An advantage of a fixed-rate interest loan is the fact that it does not change, even if there are fluctuations in the market. This type of interest is a suitable option for those who want to plan their budget in advance, especially if your income is stable but not particularly high.
On the other hand, a variable interest rate loan fluctuates so that it follows the changes in the market and adjusts accordingly. An advantage of these rates is the fact that they can drop, thanks to market fluctuations, so your monthly payments can be low for a while. A loan with a variable interest rate can be a convenient option for you if you’re planning to pay it back in a short period of time.
However, variable interest rate loans also carry a certain risk, as they can also increase dramatically. At the same time, the total cost of your loan increases, and you might find it difficult to keep up with the repayment schedule.
What is APR?
APR stands for Annual Percentage Rate. It refers to the overall cost of borrowing money during a year. It’s different from the interest rate, because it can include other costs related to your loan, such as the application fee. This is why APR gives you a more accurate picture of how much your loan really costs. Monthly interest, which is expressed as an “APY” or ”Annual Percentage Yield,” doesn’t include these fees and other loan-related costs.
In most cases, you should choose the loan with the lowest APR. However, before you do that, you should check what fees are included in this rate.
Face Value of a Bond
If you are a bondholder, this meaning of the term principal will also interest you. Principal is another term for the face value of a bond. It refers to the sum of money that a bond will be worth on its maturity date. A bond will normally mature in one to 30 years.
In most cases, the principal is $1,000, but the amount of money you invest in a bond can be lower or higher. It is important to note that we are talking about the nominal value, as the actual bond value can change due to fluctuations in the market, inflation, etc.
The amount of money you receive on the bond’s maturity date can be different from what you initially invested, but the face value stays unchanged.
Apart from the face value of a bond, as an investor you will also be paid interest. In this case, the interest charged over the principal is called the coupon rate.
Bonds are usually not considered a risky investment. You could lose your money only if the bond issuer goes bankrupt. In that situation, they will likely default on their loan obligations. Also, a callable bond could result in getting paid before the bond is fully mature, which can decrease the overall investment that you thought you made, causing you to lose money.
How Inflation Affects the Principal
Inflation changes the value of bonds, in a way. Nominally, the value of the bond doesn’t change. If the value of the bond was $5,000 at the moment you bought it, it will stay the same. The principal invested in this bond is $5,000, and you will be paid this amount on the bond’s maturity date.
However, the real value of a bond changes because its purchasing power drops due to inflation. The bond’s nominal value will still be $5,000, but it will be able to buy something lower in actual value because the value of a dollar has decreased.
The Overall Value of a Loan or an Investment
When you take out a loan, you pay back more than the amount you borrowed. The initial loan amount is called principal, while the additional costs refer to different fees and the interest paid over and above the principal. In situations where you are the one who is investing a certain principal in something, such as a bond, you have the chance to earn the interest accumulated on your investment.