Finance Definitions: Principal

In finance we hear the term "principal" quite a bit -- but we all know we're not talking about our favorite education professional. So when talking personal finance, what is principal?

Anytime you either borrow or loan money to someone, the principal is essentially the balance of the debt. With most forms of debt, the principal starts out as the initial amount of the investment. So, for example, if I buy a $10,000 bond in a company, that initial $10,000 investment is the principal of the loan. Likewise if I borrow $50,000 for a home improvement loan, that amount is the principal.

You've probably heard this term most often when talking about paying down the principal on a home loan. When you take out a 30 year loan, each payment you make on the house has a portion going toward the interest on the loan and a portion going toward the principal. This means that you're paying down the amount you owe with each payment.

As you get closer to paying off the loan, more of the payment is going toward the principal and less toward interest. This makes sense since the amount of interest charged on the loan is the interest rate times the principal. The lower and lower the amount you owe (the principal) gets, the less interest you're being charged and the more of your payment goes to reducing the balance.

This is a term that tends to come up every time you either borrow or loan someone money, so it's important to understand exactly what it means. When you're making a major purchase like buying a home, you want to understand all the details of the loan.

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