What is the Principal Amount?
When you take out a loan, the original sum of money that you borrow before adding fees, interest, and other charges, is the Principal Amount, or simply the Principal. We also refer to the original amount of a loan as the Face Value or the Face.
Nasdaq.com has the following definition of “principal amount”:
“The face amount of debt; the amount borrowed or lent. Often called principal.”
The principal amount is the lump sum
When anybody takes out a mortgage, auto loan, borrows money to go on vacation, or any type of personal loan, they are typically given a lump sum at the beginning of the loan term.
This lump sum is the principal. The borrower returns the money to the lender in monthly or quarterly payments. We call those regular payments ‘installments.’
Interest on the principal amount
The loan agreement will state how much the interest on the principal amount is. In some cases, the interest rate is fixed, but it could be variable. If you take out a loan with a variable rate, the interest the lender charges you may fluctuate.
If you want to be able to plan your finances, you should consider having a loan whose interest rate does not fluctuate, i.e., a fixed-rate loan.
The principal amount is central to the concept of amortization, which is the process of spreading out a loan into an agreed number of installments.
While each installment includes a portion that is paid toward both the interest and the principal, the exact proportion of each is not always the same – it changes over time.
During the early months or years of a loan term, a greater portion of the installments go towards paying off the interest rather than the principal. As time progresses, more and more of each payment goes toward reducing the principal.
Understanding the principal amount
Understanding the principal amount is crucial for any borrower. It impacts the total interest paid over the life of the loan. How much of the principal you have paid off in, for example, a mortgage, tells you the pace at which you are building equity. In other words, it tells you how much of the house’s value is actually yours.
Principal amount in investments
In the world of investments, the principal amount is the initial sum you invest, before any profits or earnings are considered.
Vocabulary used in this article
Below, you can see the definitions of some of the key words used in this article, plus examples of how we can use them in a sentence:
The cost of borrowing money, typically expressed as an annual percentage of the loan amount.
Example: “She noticed that the interest on her savings account was lower than the interest she was paying on her credit card.”
A fixed sum of money due as one of several payments for a loan, typically paid at regular intervals over a set period of time.
Example: “She budgeted carefully to ensure she could afford the monthly installments on her car loan.”
A loan specifically used to purchase real estate, where the property itself serves as collateral to the lender.
Example: “They just signed the papers for their first mortgage and are excited to move into their new home.”
A loan taken out specifically to purchase an automobile, which can be secured (backed by the vehicle) or unsecured.
Example: “He obtained an auto loan at a competitive interest rate to buy his first car.”
A loan provided to individuals by a bank, credit union, or online lender that can be used for personal expenses.
Example: “She took out a personal loan to consolidate her high-interest credit card debt.”
An interest rate on a liability, such as a loan or mortgage, that remains the same throughout the term of the loan.
Example: “They preferred a loan with fixed interest to avoid the uncertainty of rate fluctuations.”
An interest rate that can change over the period of a loan in response to changes in the market interest rates.
Example: “The variable rate on their home equity line of credit meant their payments could go up or down.”
This term is synonymous with fixed interest, referring to an unchanging interest rate on a loan throughout its term.
Example: “They locked in a low fixed rate for their mortgage to ensure stable monthly payments.”
The process of paying off a debt over time in regular installments, where the payment covers both principal and interest.
Example: “The amortization schedule showed they would pay off the loan in 30 years.”
The process of increasing ownership in an asset over time as the loan against it is paid down or as its value increases.
Example: “With every mortgage payment they made, they continued to build equity in their home.”