What is Principal?
If you are in the market for a loan, you have probably come across a bunch of financial terms that may or may not make a whole lot of sense. If you are feeling a bit confused, there is no need to worry. We can help you understand what it takes to get a loan, as well as what all that fancy language really means. Let's begin with one of the most basic aspects of any type of loan - principal. At some point in your life, you have probably heard this term thrown around in various settings, so it's important to understand what it entails and how it can affect your financial opportunities both now and in the future.
Simply put, principal refers to the amount borrowed or the amount still owed on a loan, excluding interest. It is important to note that the term principal takes on a different meaning depending on the context. For instance, when it comes to homeownership, principal is the part of a monthly payment that reduces the outstanding balance of a mortgage. You may have heard other people complaining about the fact that their monthly loan payments only cover the amount of interest they owe and fail to reduce the principal. If your interest rate is fairly high, it's true that it might take awhile before you actually chip away at the amount of money borrowed.
Examples of Principal
Now let's use the term principal in context. Let's imagine you have recently graduated from college and it's time to begin tackling the sizeable amount of student debt you have most likely accumulated over the past four years. If you took out a loan totaling $10,000 to study abroad one semester, the principal of the loan is $10,000 - the total amount you borrowed. Interest will be calculated on the principal.
As mentioned before, an "interest only" loan payment does not reduce the principal. Instead, your monthly payment exclusively covers the interest on the loan. On the other hand, in a loan amortization schedule, the principal and interest are separated - making it easier to see what portion of your monthly payment goes toward paying off the principal and which part is used to pay interest. Amortization is a term that refers to the process of paying off a loan by making payments which include both principal and interest. A portion of each payment is automatically put toward the principal balance and the rest of the payment covers interest.
Principal Explained in Two Sentences
Here's the take-home point: the principal is the amount you borrow when you take out any type of loan. It can also be thought of as the amount you still owe on the loan, not including interest.