'Principal' is explained in detail and with examples in the Corporate Finance edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
Principal has several different meanings. It most commonly pertains to the initial amount of money that a person either invests or borrows with a loan. A secondary meaning has to do with a bond and its face value. Sometimes the word pertains to the owners of a company or the main participants in any type of transaction.
Where borrowing is concerned, this term relates to the upfront amount of any loan. It also is utilized to describe original amounts which the individuals still owe on the loan in question. Looking at a clear example always helps to clarify the concept. When people obtain a $100,000 mortgage, this Principal is the same $100,000. As the individuals pay down $60,000 of this amount, the remainder of $40,000 that is left to pay off is similarly referred to as Principal.
It is the original Principal that decides how much interest borrowers will pay. If borrowers take out a loan with an initial amount equaling $20,000 that comes with a yearly interest rate at seven percent, then they would be required to pay $1,400 in annual interest for each year that the loan remains open. As borrowers pay the monthly payments to the loan servicer, the interest charges for the month will first be paid off. What remains goes toward the initial amount which the individuals borrowed. Paying down this original amount borrowed remains the only means of lowering the interest amount that accrues on a monthly basis.
Another form of mortgage that operates differently has the name of zero principal mortgages. Bankers think of these as interest-only loans. They represent a unique form of financing where the routine monthly payments of the borrower only apply to the loan’s interest. This means that the initial loan amount never gets paid down unless the borrower makes extra payments. It also translates to no equity building up in the property which backs the mortgage loan.
Because of this, financial advisors will typically not recommend these types of mortgages to home buyers as they are rarely in the true interest of the purchaser. Despite this fairly obvious assessment, there are a few unusual cases when they could work out for certain people. When a home buyer is starting out on a career path that pays very little initially but will later on earn substantially more in the not too distant future, it could be worthwhile to lock in the home price now while it is lower. Once the income increases apace, the borrowers always have the ability to refinance into a more traditional mortgage which would cover payments on the initial amounts borrowed as well.
Another scenario where these loans make sense relates to unusual and fantastic opportunities for a particular real estate investment deal. When huge returns on investment dollars can be anticipated, it is practical to go with these mortgage’s far lower payments that are interest-only. Meanwhile the borrower can plow the additional monthly payment money savings into the exceptional investment opportunity.
Principal also finds use describing the first initial outlay on an investment. This does not take into consideration any interest that builds up or earnings on the investment. Savers might deposit $20,000 at a bank in a savings account with interest. After a number of years, the balance will grow to $21,500. The principal remains the original $20,000 the savers gave the bank. The additional $1,500 will be called interest or earnings on top of this initial outlay.
It is interesting to note that inflation will not change the nominal value of a loan or financial instrument’s principal. Yet the effects of inflation do very much reduce the real value of the initial amount.