Principal

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What Is Principal?

Principal is the original sum of money at the center of a savings account or a loan: the amount initially deposited or borrowed, before any interest is added. On a deposit, it is the money put in; on a loan, it is the amount owed before financing charges. Interest is then calculated as a percentage of this base. Under simple interest, only the principal ever earns or owes interest. Under compound interest, accumulated interest is folded into the balance, so later interest is figured on principal plus prior interest combined. When a borrower makes payments on an installment loan, each payment is typically split between interest owed and a reduction of the principal, gradually shrinking the amount on which future interest is charged.

Why It Matters

Principal is the reference point that makes interest meaningful, because every rate is expressed relative to it. Separating principal from interest clarifies what is actually owed or saved versus what financing adds on top. On a loan, understanding that payments reduce principal explains why paying extra toward principal lowers the base that future interest is calculated on, and why balances that stay high keep generating large interest charges. On a deposit, the principal is the protected starting amount that compounding then builds upon. The distinction also underlies terms like annual percentage rate and annual percentage yield, both of which describe interest as a proportion of the principal over a year. Grasping the concept is a prerequisite for reading almost any statement involving interest.

Test Your Knowledge

Questions on this topic from the EconRecall fact bank: