What is Principal?
The word “principal” comes with various definitions in terms of investments, debt, contracts, and bonds. The principal in bonds refers to the par or face value of a bond. It is the initial investment paid for a security or bond, and it does not include any interest derived from such investments.
In contracts, a principal can refer to an agent who is acting on behalf of another person or entity. It can also refer to anyone who signed a contract and therefore is subject to the duties, rights, and obligations derived from the contract or agreement.
- The word “principal” comes with various definitions in terms of investments, debt, contracts, and bonds.
- When looking at investments, the principal amount (or simply principal) refers to the original payment made by an individual for investment purposes.
- The principal amount in loans refers to the initial amount borrowed by an individual. It also refers to the outstanding amount on a loan.
Principal in Investments
When looking at investments, the principal amount (or simply principal) refers to the original payment made by an individual for investment purposes. The amount does not include any interest earnings or revenue generated through the investment.
For example, Chris recently decided to make a $7,000 deposit into an interest-bearing account. The interest received on the account is 5% per annum. Chris decides to leave his investment untouched for ten years.
At the end of the ten years, there is $11,402 in his account. The original or initial deposit of $7,000 made by Chris is the principal amount. The difference between the $11,402 and the $7,000 investment is the interest that Chris earned ($4,402) during the period.
Principal in Debt
The principal amount in loans refers to the initial amount borrowed by an individual. It also refers to the outstanding amount on a loan. For example, Lucinda takes out a personal loan of $65,000 from her bank. She’s already paid off $35,000 of the original amount. The balance due on the loan is known as the principal balance. The $65,000 is the principal amount.
The principal amount is used in the determination of the monthly, annual, or quarterly interest payments. For example, Lucinda’s loan was taken out with a 7.25% interest on the principal per annum. The interest in the first year is $4,712.50.
The amount is calculated by multiplying the principal balance by the interest rate and adjusting for the relevant period (annual, monthly, or quarterly). The reduction of the principal amount allows for a reduction in interest payments.
Loan repayments are normally structured in a way that monthly repayments cater to the interest payments (finance costs) and the difference is used as a reduction of the principal amount.
Bonds are fixed-income securities that are issued by governments and corporations to raise capital. The bond issuer borrows capital from the bondholder and makes fixed payments to them at a fixed (or variable) interest rate for a specified period.
The principal amount in debt instruments is also known as the face value or the par value of the bond. The principal is the amount that an issuer is borrowing and is set to repay when the bond matures. The repayment is made to the bondholder.
It should be noted that the principal of a bond does not include the coupon payments, the frequent interest payments, or any outstanding interest payments. An example would be an 8-year bond issued with a $1,000 par value with $50 semi-annual coupon payments. The principal amount of the bond is $1,000 regardless of the coupon payment,s which amount to $800.
It should be also noted that the market price of a bond and its principal are not always the same. Bond market prices fluctuate depending on various market-related conditions. Hence, a bond may sell below or above its par value, but its par value will remain unchanged.