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The principal amount is the face value of a loan or debt security. When an individual or business borrows a certain sum of money through a loan, the amount borrowed is referred to as the principal amount. In most cases, a borrower will repay a portion of the principal with each monthly payment that they make on a loan.
One common area in which borrowers are aware of their principal amount is with their mortgages. When a borrower gets a mortgage for $100,000 US Dollars (USD) to purchase a home, the principal amount is $100,000 USD. This does not represent the total amount of money that will be paid to the lender over the life of the loan. The lender also will be paid interest in return for loaning the money to the borrower.
When repaying a traditional mortgage, a borrower will make regular monthly payments back to the lender. Each payment will be comprised of interest and principal. At the beginning of the mortgage, the vast majority of the payment will be interest, and a small percentage will be principal. For example, with a $1,000 USD mortgage payment, $950 USD of it might be interest, and the remaining $50 USD would be principal. This $50 USD is going to go toward the amount that was borrowed and will reduce the amount of money that is owed to the lender.
As the principal decreases over time, an increasing amount of the mortgage payment will go toward the principal. At some point, the majority of the mortgage payment will become principal, and there will be only a small amount of interest to be paid each month. When the entire principal amount has been repaid, the loan will be retired, and the monthly payments will cease.
In addition to mortgages, the term "principal amount" is used in other areas as well. In the bond market, investors sometimes refer to the face value of the bond as the principal amount. When an investor gets involved with the bond market, he or she essentially is loaning money to a corporate entity or government entity. The entity then pays the investor a set amount of interest over the life of the bond. At the end of the term, the investor gets back the principal amount that he or she originally invested.
In other forms of investment, the principal is used to describe the amount that was the original investment. In a trading account, for example, if an investor's account was valued at $10,000 USD and he or she originally had invested $6,000 USD, the principal amount would be $6,000 USD. The remaining $4,000 USD would be the profit from the investments.