In a financial context, the word principal has profuse definitions in terms of debt, equity, bonds, contracts, etc.

It is the amount of money that is being lent on top of which interest is paid to the lender.

However, Principal in bonds is the par value or face value of the bond.

It is an initial investment processed for a bond and does not include any interest derived from such investments.

On other hand, a Principal in a contract refers to the one who acts as an agent on behalf of another person or entity.

Role of Principal in Investments

In an investment context, the principal is the total sum of money paid by an investor for investment purposes. The amount does not include any interest earnings or revenue generated from the investment.

For example, A invested Rs.7000 into an interest-bearing account. The rate of interest is 5% per annum and it is invested for a period of10 years. Hence at the end of the tenure, A will receive Rs.10,500 into his account. Therefore, the original investment of Rs.7000 is the principal amount and the difference between 10,500 and 7000 is the interest earned at the end of the tenure.

Role of Principal in Debt

Debt issuance is processed either by giving a loan or by issuing a certificate in the form of a bond or both ways :

Under Loan

Under a loan facility, the principal amount is the initial amount borrowed by an individual or an entity.

For example, XYZ decides to borrow an educational loan of Rs. 5,00,000 from the bank

Out of which Rs.1,00,000 is repaid out of the original loan amount. Therefore the balance amount of Rs. 4,00,000 is called as principal balance and Rs. 5,00,000 is the principal amount.

The principal amount is crucial as it helps to determine the rate of interest at which the loan is provided.

Under Bonds

Bonds are fixed-income securities issued by the government or any other entity to raise funds.

Under bonds, the issuer borrows money from the bond investors and generates fixed interest periodic payments for a specific period.

Therefore, the principal is the amount of money an issuer is borrowing and promises to repay when the bond matures.

For example, ABC issued a bond with a face value of Rs.1000 for 8 years with 5% coupon payments paid semi-annually... The principal amount of the bond is Rs. 1000 having a coupon payment of Rs.800 in total.

In regards to bonds, the principal amount and the market value of the bond are not always in line as the market value of the bond fluctuates in response to the market conditions.