The term “principal” has a lot of meanings even within the economic sphere. It can be viewed from different perspectives that are presented in the graph below.
Let’s consider all the aforementioned meanings of the term in particular.
Principal as a loan
In the context of loans the principal is an exact amount of money that a borrower gets from a lender. In other words, it’s a body of the loan. For example, you get a mortgage of $300,000 to buy a property. Basically, this sum is the principal. Some time afterwards, you pay back $100,000. Now your principal is $200,000. As you can see, the principal is not only the initial amount of borrowed money, but also the part left unpaid, i.e., unpaid principal balance. The principal doesn’t include the accrued interest on the loan, taxes, insurance, or other additional payments.
Mortgage. There is a specific type of loan as a mortgage. It’s one of the most affordable ways of buying property or other real estate. The interest of the loan depends on a credit score and credit history of the borrower which reflect the level of his creditworthiness. Also, the lender considers the type of loan, its duration, and down payment.
There are a few types of the mortgage payments, but let’s shortly review the following two:
- When you pay most of the interest payments ahead of the principal.
- When you pay the interest and the principal at the same time.
The first type of payment helps you to reduce monthly payments. Usually, they are equally distributed through the length of the loan which can be stretched to 15-30 years or more. But the final sum of the mortgage payment will be much bigger than it could be with another type of payment.
The second method helps you to reduce the whole amount of payments, because the interest charges depend on the principal. A principal reduction, or a decrease of mortgage payment, is one of the best ways to cut down interest expenses. In other words, when the initial sum of the loan gets smaller, the interest charges get smaller too.
Also, let’s take attention to another type of the mortgage payment – a zero-coupon mortgage. It is a commercial type of payment that promises you beneficial conditions on the loan. Though it might be advantageous in some cases, it contains a lot of risks. Lenders don’t work to their detriment, so neither of them will literally give you a mortgage with zero interest rate. The zero-coupon mortgage is an opportunity to delay your payments to a maturity date of the mortgage. At first, you’re going to pay off a little amount of interest charges or none of them at all. However, the greater part of payments, including all the interest charges and the principal, you’ll need to cover till the maturity date. This type of payment might be profitable for some businesses which accumulate a great amount of capital by the time their projects such as a concert venue or stadium are done.
Bonds. The principal is also a face value or “par value” of the bond. It’s the initial amount of borrowed money that the issuer of the bond will pay back to the bondholders. For example, you buy a 3-year bond for $1,000. The principal of this bond is $1,000. The annual coupon payments that you can get while holding the bond aren’t included in the principal.
Note that market conditions are constantly changing, thereby the bond can be sold on the secondary market above or below its initial price. In other words, the bond can be sold at a premium or at a discount, correspondingly. However, the principal always stays the same. Thus, if you buy a bond for $1,100, or at a $100 premium, its initial price, or the principal, won’t change – $1,000.
Inflation rate. It’s important to take inflation into consideration. The principal of the loan isn’t going to change with the inflation rate, but the real value of the money can get under its influence. For instance, if you have a 3-year bond of $5,000, by the maturity date the inflation rate of 6,5% will change the real value of this sum to $4,674.97, i.e., to 93% of its initial purchasing power. Note that the initial sum of the loan stays the same – $5,000. The changes apply only to the value of this money 3 years hence.
The inflation loss can be compensated by a coupon income, i.e., a bond yield. This term has a few meanings as well, but here we consider it only as the coupon income. If this income overcomes the loss, the bondholder will get profit despite the inflation influence. In order to get a more correct estimation of your possible loss or profit you can count a nominal and current yield of the bond.
Principal as an investment
As aforesaid before the term “principal” has several meanings. It’s not only the initial sum of the loan or the face value of the bond, but also the initial sum of investment. Let’s explain it with the following example. You put $3,000 in a deposit account for 3 years. By the end of this period your investment will have grown to $3,900. The principal you invested is the same – $3,000, but you also gain earnings from this investment – $900.
There is another strategy of growing your income – a compounding. Basically, this process helps you to increase the principal by adding to it the amount of interest payments. Consequently, the interest payments will gradually grow with the principal. For example, with the compounding effect your principal of $3,000 will grow to $3,300 after the first year. Next year the interest payment will be calculated from this sum: $3,300 x 10% = $330. By the end of the third year your deposit will have grown to $3,993.
Principal as an owner
The term “principal” refers to the owner of a private company, partnership, or corporation. This person doesn’t necessarily have to be a chief executive officer (CEO) or managing director. It can be a person or group of people owning the controlling stock of the company’s shares.
The principal in some ways, can be a public face of the company, because investors often use the information about the owner for assessing the company’s creditworthiness.
Principal as a responsible party
The principal is also the person responsible for different transactions on behalf of a company or account. This activity requires a high level of responsibility. However, this authority always has associated risks that the principal should take into consideration.
The principal can be an individual, partnership, or nonprofit organization. The authority to make transactions can be given to an agent, who will act on the principal’s behalf. Nevertheless, this decision won’t reduce the risks, because the principal suffers from the consequences of the agent’s action or inaction.
For example, you hire a financial advisor to be responsible for your investment account. You may establish a limited power of attorney stating that the advisor can act on your behalf. You are the principal and the advisor is your agent, or fiduciary. However, if the agent makes a mistake that negatively influences your investment account, you'll be the one who suffers the consequences.