What does the term 'principal' refer to in finance?

In finance, the term 'principal' specifically refers to the original sum of money that is either borrowed or invested, distinct from interest or other fees associated with a financial transaction. When you take out a loan, the principal is the initial amount you are borrowing before any interest is added. In investments, it is the initial amount of capital that is put to work, which will earn interest or generate returns over time.

Understanding the concept of principal is crucial as it serves as the foundation for calculating interest. For instance, if you have a loan, the interest is typically calculated as a percentage of this principal amount. Therefore, the principal can significantly impact the overall costs of borrowing or the growth of an investment, making it a fundamental concept in personal finance.