In investing, the principal is the cash you hold in an investment account. If you’re borrowing money, the principal is the actual amount you borrow, before interest begins to apply. For both loans and investment accounts, the principal represents the foundation upon which everything else is paid off or built, respectively. It’s a fundamental concept that’s crucial to understanding both lending and investing practices.
Do you have questions about how investing can be part of your financial plan? Speak with a financial advisor today.
What Is the Principal of a Loan?
When you take out a loan, the principal can refer to either the original value of the loan or the amount you still owe. If you take out a $100,000 mortgage loan, the principal is $100,000. If you pay off $60,000 of that mortgage, the remaining $40,000 is the principal.
The initial principal of a loan also determines the amount of interest paid on that loan. That same $100,000 mortgage with an annual interest rate of 4% would require an extra $4,000 in interest payments each year for the life of the loan.
A mortgage payment typically pays both the accrued interest on the loan and a portion of the principal. To reduce the amount of interest paid over the life of the loan, you have to pay down the principal.
While there are zero-principal, interest-only mortgages, they don’t tend to work in the borrower’s favor. Such mortgages feature payments that cover only the interest charged on the loan. Those payments are smaller, but don’t pay down principal or pay off the debt. That prevents homebuyers from building equity in their properties.
Zero-principal mortgages might make sense for investment properties or for people just starting their career. However, even those exceptions are best served by refinancing to a standard mortgage and paying down principal.
What Is the Principal of an Investment Account?
Regardless of the type of investment account you open, you’ll need a specific dollar amount to start your account. This is usually determined by the broker or company you open an account with.
The initial deposit you open your account with is its principal, as is any additional money you subsequently deposit in the account. If you open an investment account with $1,000 that grows to $3,500 within 10 years, the principal is still the original $1,000. The remaining $2,500 are your earnings, or return.
In the case of a bond, the face value is the principal. This is the amount that a bond issuer owes the bondholder once the bond reaches maturity. It doesn’t included coupon payments or interest payments. A $5,000 10-year bond with $50 semi-annual coupon payments still has a $5,000 principal that doesn’t include the nearly $500 in payments through the duration of the bond.
Fluctuations in the bond market mean the purchase price of a bond may be greater or less than its principal. A $1,000 bond can sell for far more if it’s in high demand, but its principal would remain the same.
Understanding the Return of an Investment Account
Your return is what you earned on an investment. Take your current balance, minus the principal investment, and you’ll get your return on investment, or ROI.
The ROI can come in the form of interest, dividends and earnings. Using the earlier example, take your total profits ($3,500) minus the principal balance ($1,000) and you get the return: $2,500.
Though some investment firms allow you to start investing with as little as $1, growing your return from that principal is far more difficult. As you might expect, the more you contribute to your investment account, the more you could earn. Even adding $20 every month can help. If you want to increase your return, but don’t know if you can make a monthly contribution, try to set aside more money when you start investing.
How Does Inflation Affect Your Principal?
Inflation doesn’t directly affect the size of your principal, though inflation could make it less valuable over time. That’s because, as inflation takes effect, your money won’t be worth what it was when you made your investment.
Say, for example, you invested $5,000 in a bond in 2010. When 2023 rolls around, you would need to invest $6,252 to have the same financial impact as your original investment. That’s because, according to SmartAsset’s inflation calculator, the cumulative inflation rate over that time frame was 25.05%.
When it comes to a loan’s principal, inflation will have no affect on it whatsoever. In fact, a borrower could benefit from inflation if wages rise because of it during the course of their loan’s life. In this case, you’d receive more money even if you didn’t switch jobs, giving you more money to pay back your loan. By paying off your loan faster, you’ll incur significantly less in interest charges as well.
However, inflation can also be a catalyst for price changes. Under these circumstances, a lender would benefit more, as the borrower would have to take out more money to finance something that may have cost less in the past.
When you break down your total investment amount, make sure you know the difference between how much you’re earning and how much you’ve contributed. While the two are related, the distinction matters.
Whether you’re making your first investment or just looking to bulk up current investments, take note of how much principal you have or will have. If you’re able to invest more toward the principal, it could have a significant effect on your return. If you’re wondering if you have enough in principal to make an investment worthwhile, you may want to consider talking to a financial professional.
- If you’re new to the world of investing, it might be helpful to dive in with the help of a financial advisor. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- As noted earlier, a little extra principal could lead to a bigger return. If you want to see just how big that return can get, SmartAsset’s investment calculator can help.
Photo credit: ©iStock.com/g-stockstudio, ©iStock.com/Nikada, ©iStock.com/wutwhanfoto