The principal is the start of your your investment journey. You need some cash to open an account, and your initial deposit is the principal amount. When investing, the principal is the amount you initially invested. For both accounts and investments, the principal represents the foundation upon which everything else is built. It’s a fundamental concept, but one that’s crucial to understanding both savings and investment.
The Principal for Loans
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 also known as 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.
The Principal of Bonds
The face value of a bond is also known as the principal. It 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.
What Is the Principal of an Investment?
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. 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.
What Is the Return of an Investment?
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.
Why Does the Principal Amount Matter?
The principal amount — the original balance — is your unofficial entry fee into investing. The more you contribute to your principal, the better your chances for a high return.
If your principal is $1,000 and you earn 5% interest every year for five years, you’re set to earn $250. If your principal is $10,000 with a 5% interest earned in the same time frame, your return will be $2,500.
Can You Grow Your Return Faster?
Though some investment firms allow you to start with as little as $1, growing your return from that principal is far more difficult.
The more you contribute to your investment account, the more you’re set to earn. Even adding $20 every month, like $20 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.
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 devoted to principal to make an investment worthwhile, you may want to consider talking to a financial professional.
- If you consult a financial adviser, you are also considered the principal to your investment decisions. They are the agent. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- Still wondering how a the principal affects your mortgage? SmartAsset’s mortgage calculator can help you determine what your mortgage payments will look like if you apply more toward the principal.
- 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 investing calculator will give you some idea of just how far your principal can go.