What Is Principal?
“Principal” is a term that has several financial meanings. The most commonly used refers to the original sum of money borrowed in a loan or put into an investment. Similar to the former, it can also refer to the face value of a bond. Principal can also refer to an individual party or parties, the owner of a private company, or the chief participant in a transaction.
- The term “principal” has several meanings in the financial and business world.
- In the context of borrowing, principal is the initial size of a loan or a bond (the amount the bond issuer must repay).
- In the context of investing, principal is the original sum committed to the purchase of assets—independent of any earnings or interest.
- In business, principals are those who own a majority stake in a company and/or play a significant role in running it.
- In contracts and contractural ventures, principals are the chief parties involved in the transaction who have rights, duties, and obligations regarding it.
Understanding Principal: Loans
In the context of borrowing, principal is the initial size of a loan; it can also be the amount still owed on a loan. If you take out a $50,000 mortgage, for example, the principal is $50,000. If you pay off $30,000, the principal balance now consists of the remaining $20,000.
The amount of interest you pay on a loan is determined by the principal. For instance, if your loan has a principal amount of $10,000 and an annual interest rate of 5%, you will have to pay $500 in interest for every year the loan is outstanding.
When you make monthly payments on a loan, the amount of your payment goes first to cover accrued interest charges; only then is the remainder applied to your principal. Paying down the principal of a loan is the only way to reduce the amount of interest that accrues each month.
A zero-coupon mortgage is a type of financing in which the borrower’s regular payments cover only the interest charged on the loan, as opposed to both interest and principal. As a result, the borrower does not make any progress in reducing the loan’s principal balance—or on building equity in the mortgaged property.
Understanding Principal: Investing
Principal is also the original amount of investment made in an asset, separate from any earnings or interest accrued. For example, assume you deposit $5,000 in an interest-bearing savings account. At the end of 10 years, your account balance will have grown to $6,500. The $5,000 you initially deposited is your principal, while the remaining $1,500 is attributed to earnings.
|The Various Definitions of Principal|
|Different Types of Principal||Definition|
|Loans||The sum of money borrowed|
|Investments||The amount of money put into an investment|
|Bonds||The face value of a bond|
|Companies||The owner of a private company, partnership, or other type of firm|
|Transactions||The party that has the power to transact on behalf of an organization or account and takes on the attendant risk, whether it be an individual, a corporation, a partnership, a government agency, or a nonprofit organization.|
Understanding Principal: Bonds
In the context of debt instruments, principal is the amount of money the issuer of a bond is borrowing and will repay to the bondholder in full upon the bond’s maturity. A bond’s principal is also known as its “par value” or “face value” (because, back in the days when bonds were actual physical pieces of paper, this amount was printed on the face of the bond itself). The bond’s principal is exclusive of any coupon, recurring interest payments, or accrued interest (although the issuer is obligated to pay these as well). For instance, a 10-year bond may be issued with $10,000 face value and have $50 recurring coupon payments semiannually. The principal is $10,000, independent of the $1,000 worth of coupon payments over the life of the bond.
Except when it is first issued, a bond’s principal is not necessarily the same as its market price. Depending on the state of the bond market, a bond may be purchased for more or less than its principal. For example, in October 2016, Netflix issued a corporate bond offering. The face value or principal of each bond was $1,000, and at issue that was the price of each bond as well. Since then, the bond price has fluctuated between $1,040 and $1,070, but the principal has remained the same: $1,000.
How Inflation Affects Principal
Inflation does not affect the nominal value of the principal of a loan, bond, or other financial instruments. However, inflation does erode the real value of the principal.
Suppose the U.S. government issues $10 million worth of 10-year U.S. Treasury bonds. Each treasury has a face value, or principal, of $10,000. If the average annual rate of inflation over the next 10 years is 4%, then the real value of those bonds at maturity is only $6,755,641.69. Yes, the principal balance remains $10,000, and that’s the nominal sum bondholders receive. However, the value of that $10,000 (that is, what it can buy) has declined to, effectively, $6,755.64. In other words, the principal has only 67% of its original purchasing power.
Bondholders can still recoup their original costs if the value of the interest income the bond has generated is greater than the lost principal value. They can track the amount of return, or yield, they’re getting on a bond. There’s the bond’s nominal yield, which is the interest paid divided by the principal of the bond, and its current yield, which equals the annual interest generated by the bond divided by its current market price.
Understanding Principal: Private Companies
The owner of a private company, partnership, or other type of firm is also referred to as a “principal.” This is not necessarily the same as a CEO. A principal could be an officer, a shareholder, a board member, or even a key sales employee—basically, it’s the primary investor or the person who owns the largest share of the business.
A company may also have several principals, who all have the same equity stake in the concern. Anyone considering investing in a private venture will want to know its principals in order to assess the business’ creditworthiness and potential for growth.
Understanding Principal: Responsible Parties
The term “principal” also refers to the party who has the power to transact on behalf of an organization or account and takes on the attendant risk. A principal can be an individual, a corporation, a partnership, a government agency, or a nonprofit organization. Principals may elect to appoint agents to operate on their behalf.
The transaction a principal is involved in could be anything from a corporate acquisition to a mortgage. The term is usually defined in the transaction’s legal documents. In those documents the principal is everyone who signed the agreement and thus has rights, duties, and obligations regarding the transaction.
When a person hires a financial advisor, they are considered a principal, while the advisor is the agent. The agent follows instructions given by the principal and may act on their behalf within specified parameters. While the advisor is often bound by fiduciary duty to act in the principal’s best interests, the principal retains the risk for any action or inaction on the part of the agent. If the agent makes a bad investment, it is still the principal who loses the money.