Principal

By:

Arti

Arti is a specialized AI Financial Assistant at Invezz, created to support the editorial team. He leverages both AI and the Invezz.com knowledge base, understands over 100,000... read more.

Reviewed by:

Idil Woodall

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Updated:  Jun 17, 2024

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4 min read

3 key takeaways

• Principal is the initial amount of money invested, loaned, or borrowed.
• It forms the basis for calculating interest or returns on investments.
• Repayment of loans involves both the principal and the interest accrued over time.

What is principal?

Principal is the term used to describe the original amount of money invested in an asset, loaned to a borrower, or borrowed from a lender, before any interest, dividends, or returns are added.

In the context of loans, it is the amount of debt that must be repaid, excluding any interest or fees. For investments, it is the initial amount of money placed into an investment vehicle.

Importance of principal

Understanding the concept of principles is crucial for various financial activities:

• Loans and Mortgages: The principal is the amount borrowed that needs to be repaid. Interest is calculated based on the principal amount, and loan repayments typically include both principal and interest components.
• Investments: The principal is the amount of money initially invested. Returns or interest earned on this principal contribute to the overall growth of the investment.
• Savings: In savings accounts, the principal is the amount deposited, and interest earned on this principal helps in growing the savings over time.

Calculation of interest on principal

Interest can be calculated on the principal using different methods, primarily simple interest and compound interest.

1. Simple Interest: This is calculated on the principal amount alone.

   • Formula: Simple Interest = Principal × Interest Rate × Time
   • Example: If $1,000 is invested at an interest rate of 5% per year for 3 years, the simple interest would be $1,000 × 0.05 × 3 = $150.

2. Compound Interest: This is calculated on the principal amount and also on the accumulated interest of previous periods.

   • Formula: Compound Interest = Principal × (1 + Interest Rate / Number of Compounding Periods)^(Number of Compounding Periods × Time) – Principal
   • Example: If $1,000 is invested at an annual interest rate of 5%, compounded yearly for 3 years, the compound interest would be $1,000 × (1 + 0.05)^3 – $1,000 ≈ $157.63.

Repayment of principal in loans

Loan repayment involves paying back the principal amount along with interest. The repayment schedule typically includes:

• Principal Repayment: A portion of each payment goes towards reducing the principal balance.
• Interest Payment: A portion of each payment covers the interest accrued on the remaining principal balance.

Example of loan repayment

Consider a $10,000 loan with an annual interest rate of 5% and a repayment period of 5 years. Monthly payments would include both principal and interest. Over time, as the principal is repaid, the interest portion of the payment decreases, and more of each payment is applied to the principal.

Principal in investments

In investments, the principal is the initial amount of money put into an asset or account. The returns on investment, whether in the form of interest, dividends, or capital gains, are earned on this principal amount.

Example of investment growth

If an individual invests $5,000 in a mutual fund with an annual return rate of 6%, the value of the investment will grow based on the returns earned on the principal. After one year, the investment would be worth $5,000 × (1 + 0.06) = $5,300.

Principal is a fundamental concept in finance, underlying loans, investments, and savings. It represents the core amount of money on which interest and returns are calculated, playing a crucial role in financial planning and decision-making.

For further insights, explore related topics such as interest calculation, loan amortization, and investment strategies.