Financial Word of the Day: Principal

When it comes to money, sometimes the simplest words are among the most important. Principal is one of them.

You’ll hear this term constantly when talking about mortgages, car loans, investing, and even retirement accounts. Understanding what principal means can help you make better decisions about both borrowing money and growing money.

What Is Principal?

In lending, principal is the amount of money you actually borrow.

Suppose you buy a $300,000 house and make a $60,000 down payment. You borrow the remaining $240,000.

That $240,000 is your original principal.

But your mortgage payment doesn’t simply repay the $240,000. Part of your payment goes toward interest, the price you pay the lender for using their money, and part goes toward reducing the principal.

That distinction matters.

Especially during the early years of a traditional mortgage, a surprisingly large portion of your payment may go toward interest rather than principal. As the principal balance declines, the amount of interest charged generally declines as well.

Principal Works in Investing, Too

Principal isn’t just a borrowing term.

If you invest $10,000 into an investment account, that $10,000 can be considered your principal investment. If it eventually grows to $15,000, you’ve earned $5,000 on your original principal.

And this is where principal becomes exciting.

When your principal earns a return, and those earnings begin generating additional returns, you experience the power of compound growth.

A larger principal gives your money a larger base from which to grow.

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Why Principal Matters to You

Understanding principal can help you make smarter financial decisions.

For example, suppose you have a mortgage with a $250,000 principal balance and receive a $10,000 bonus. If your loan allows additional principal payments without penalty, applying that $10,000 directly toward principal could reduce the amount of interest you pay over the life of the loan and potentially help you become debt-free sooner.

On the investing side, increasing the amount of principal you invest can dramatically affect your future wealth.

Invest $10,000 at a hypothetical 8% annual return for 30 years, and it could grow to roughly $100,000 without adding another dollar.

Start with $50,000 under the same assumptions, and you're looking at roughly $500,000.

Same rate. Same amount of time.

The big difference? Principal.

Using "Principal" in Conversation

You might hear someone say: "I'm making an extra payment this month and applying all of it toward the principal on my mortgage."

Or: "Instead of spending my bonus, I'm adding it to my investment principal and letting it compound."

Both statements reveal an important financial principle: The amount of principal you owe affects the cost of your debt. The amount of principal you own affects your ability to build wealth.

Reduce the first. Grow the second. That’s a pretty good financial strategy.

Today’s Money Move

Look at one loan and one investment account you currently have. Identify the principal balance of each. Then ask yourself two questions: How can I reduce the principal I owe faster? And how can I increase the principal I own?

Learning the language of money helps you make better financial decisions, and better decisions can lead to greater financial freedom.