The term principal can have many different meanings in the financial system. People usually see it appear when securing forms of medium-to-long term credit such as loans and mortgages.
However, the use of this term extends a lot further. It’s possible to find a “principal” appearing in many other financial and legal documents.
To help clear up any confusion around this widely used title, this page explains in greater detail when the term principal might appear. It looks specifically at the sort of financial instruments that may make reference to this name and what it refers to in each case.
What is a Principal in a Loan Agreement?
With a loan, the principal often refers to the amount of money being borrowed by a business or an individual. This is the most commonly used occurrence of “principal” you’ll normally find as a financial expression.
In this case, it is a shortened form of “principal sum” and it refers to the amount of money that is lent to the borrower. It is often also initially used to set the amount of interest that must be paid on the original loan.
During monthly payments, money is first deducted from the amount of interest before it is taken from the principal itself. Normally the principal will fall gradually over time as it is repaid.
For instance, if you are borrowing $70,000 and you’ve paid off $30,000 already, the principal will now be $40,000. To complete the payment of the loan, it is always necessary to repay the principal in its entirety.
This is also the situation in terms of repayments. In this case, the amount of money that is being paid back each month that isn’t covering the interest on the loan can also be known as the principal amount.
What is a Principal in Terms of Bonds?
A principal in terms of commercial and government bonds refers to the amount of money borrowed by the issuer of the bond. This is the value that must be paid back once the bond reaches maturity, usually with some extra interest on top.
In the case of this type of debt instrument, it is possible that the principal and the market price can vary if the bond is sold to another debt holder. For example, the principal amount or face value of the bond never changes once it is issued. However, the price for the bond can fluctuate depending on its perceived value and the state of the market at the time.
What is a Principal in a Mortgage?
The principal in a mortgage agreement is much like the principal in a bank or government loan, in that it makes reference to the “principal sum” borrowed. Like with a normal loan, the amount of money repaid that contributes towards the initial sum borrowed can also be called the principal amount in context.
Of course, being a form of commercial debt, interest must be paid on top of the principal amount. Only once the borrowed sum is fully paid off can the mortgage be properly closed.
Be aware that whilst it is possible to pay off the overall principal ahead of the agreed schedule, the mortgage broker may charge penalties for doing so.
What is a Principal in an Investment?
When investing an amount of money in stocks or a business, the sum first provided is known as the principal. As the market is fluid, the value of the quantity invested may rise or fall.
However, In this situation, the amount that was originally invested is used as a gauge for the investor to see whether their venture has paid off or not. This can often be a key indicator for when it is time to sell the stock or shares.
Is a Financial Principal Affected by Inflation?
Principals aren’t numerically affected by inflation as their face value remains the same throughout the repayment process. In all cases, the statistical amount borrowed must be the same that is eventually refunded to the bondholder or loan provider.
However, inflation can hit the overall value of the amount of money that has been borrowed. For instance, if $10,000 is borrowed, inflation will occur over the payment period meaning that whilst it is numerically the same its inherent value will drop.
Ideally, the bond or loan should pay back enough money to beat the gradual rate of inflation otherwise money will be lost by the lender. At present, average inflation sits at around 3.15% per year although the Fed rate in the US is currently set much lower at 1.75-0.25% to stimulate borrowing.
Who Can Be Referred to as a Principal in a Private Company?
The meaning of principal shifts slightly in terms of its business use. In private companies, this can refer to individuals who hold a majority stake in the entity or, alternatively, someone who has a significant part in the running of the organization.
It is quite common for a company to have more than one principal to manage its fundamental workings.
Who is a Principal in a Power of Attorney
A principal can also refer to an appointing individual in a Financial Power of Attorney agreement. If this is the case, the principal is represented by an Attorney-in-Fact (also known as an agent), who can carry out specified transactions and fiscal activities on their behalf.