What Is the Principal?
The 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.
The principal can also refer to an individual party or parties, the owner of a private company or the chief participant in a transaction.
In the context of borrowing, principal refers to the initial size of a loan; it can also mean 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 remaining $20,000 left to repay is also called the principal.
The amount of interest one pays on a loan is determined by the principal sum. For instance, a borrower whose loan has a principal amount of $10,000 and an annual interest rate of 5% 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, and the remainder is 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.
Zero Principal Mortgage
Also known as an "interest-only mortgage," a zero principal 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 reducing the loan's principal balance – on paying off the overall debt – or on building equity in the mortgaged property.
For this reason, zero principal mortgages are usually not in a homebuyer's best interest. However, there are some instances when they would be useful for some individuals. If a borrower is just beginning a career in which he or she currently receives relatively little pay but will likely earn significantly more in the near future, then it might be advantageous to take such a loan now in order to buy a residence. Then, when income increases, refinance to a conventional mortgage that includes principal payments. Also, if an individual has access to an exceptional investment opportunity, promising large returns on cash, it would, in theory, make good financial sense to take advantage of the mortgage's smaller interest-only payments, and then use the extra money for the investment.
The principal is also used to refer to the original amount of investment, separate from any earnings or interest accrued. Assume you deposit $5,000 into an interest-bearing savings account, for example. At the end of 10 years, your account balance has grown to $6,500. The $5,000 you initially deposited is your principal, while the remaining $1,500 is attributed to earnings.
Face Value of a Bond
In the context of debt instruments, the principal can refer to the face value, or par value, of a bond – that is, the actual amount listed on the bond itself. A bond's principal is, essentially, the amount of money the issuer of the bond owes to the bondholder in full upon the bond's maturity. The bond's principal is exclusive of any coupon, or 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 semi-annually. The principal is $10,000 – independent of the $1,000 worth of coupon payments over the life of the bond.
A bond's principal is not necessarily the same as its 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.
Does Inflation Affect 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 percent, 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. But the value of that $10,000 (what it can buy) has declined to, effectively, $6,755.64. In other words, the principal has only 67 percent 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.
The owner of a private company is also referred to as a principal. This is not necessarily the same as a CEO. A principal could be an officer, shareholder, board member or even a key sales employee – 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.
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, corporation, partnership, government agency or 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 means everyone who signed the agreement and thus has rights, duties, and obligations regarding the transaction.
When a person hires a financial adviser, he or she is considered a principal while the adviser is the agent. The agent follows instructions given by the principal and may act on his or her behalf within specified parameters. While the adviser 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.