The principal is a term that has several meanings depending on the financial context.
In the context of loan financing, a principal is known as the amount of money agreed to be paid by a borrower to the lender when the loan is due, prior interest. All loans, whether it is a student loan, mortgage, or personal loan, start as principal, and for every designated period that the principal remains unpaid in full the loan will accrue interest and other fees.
Usually, when a payment is made on the loan, the amount of the payment first covers accrued interest charges, then the remainder is applied to the principal.
The interest that a borrower has to pay is calculated with the principal. For instance, if John takes a loan with a principal amount of $70,000 and an annual interest rate of 5%, John will have to pay $3500 in interest every year the loan is outstanding.
In investing, the principal is the cash one puts into an investment account. For example, let’s assume Derrick deposits $2000 into an interest-bearing savings account. After the end of 3 years, the account balance will have grown to $2500. The $2000 Derrick initially deposited is his principal, while the remaining $500 is attributed to earnings or return.
The return is what Derrick earned on his investment. The return or ROI can be easily determined by subtracting the principal from the current balance in an investment account.
In bonds, the principal refers to the face value of a bond. A bond principal is the amount of money the issuer of a bond is borrowing and will repay to the bondholder in full at the bond’s maturity date.
Bonds have three elements: the principal, the coupon rate, and the maturity date.
The coupon rate is the percentage of the principal paid back to the investor as interest. The bond’s principal is independent of any coupon. To further illustrate, let’s assume that a 20-year bond was issued with a $20,000 face value and has $50 recurring coupon payments semiannually. The principal is $20,000, exclusive of the $1,000 worth of coupon payments over the life of the bond.