Principal Amount

Definition

The principal amount refers to the original sum of money borrowed or invested, excluding interest or other additional sums. It is the face value of an obligation such as a bond or a loan that must be repaid by the borrower to the lender at maturity. This value is distinct from the interest, which is the cost of borrowing the principal amount.

The principal payments themselves are not tax-deductible. However, for loans receivable, any principal receipts (loan repayments) are not considered taxable income. Conversely, principal receipts gained from selling an asset may be taxable if the sale was classified as an installment sale for tax reporting purposes.

Examples

Bonds: A bond issued with a principal amount (or face value) of $1,000 will have this amount returned to the bondholder at maturity, apart from any interest earned.
Mortgage Loans: A homeowner taking a mortgage loan of $200,000 has a principal amount of $200,000. The amount to be repaid over the life of the mortgage, excluding interest, is the principal.
Installment Sale: If a seller agrees to allow the buyer to pay the purchase price over time, each payment includes a portion of the principal. If reported as an installment sale, the principal receipts may be taxable.

Frequently Asked Questions (FAQs)

What is the difference between principal and interest?

Principal is the original sum of money borrowed or invested, while interest is the cost of borrowing that principal. Interest is calculated on the principal amount.

Can principal payments be deducted from taxes?

No, principal payments are not tax-deductible. Only interest payments on certain types of loans (e.g., mortgage interest) might be deductible under specific conditions.

Are repayments of principal taxable income?

For loans receivable, repayments of the principal are not taxable income. However, principal receipts from a sale may be considered taxable if it was reported as an installment sale.

How do principal payments affect a loan balance?

Principal payments reduce the outstanding loan balance, decreasing the total amount due.

An installment sale is a sale of property where the seller receives at least one payment after the tax year in which the sale occurs. The principal received in installment payments may be taxable.

Face Value

The face value is the nominal value of a bond or other security as stated by the issuer, which will be repaid to the investor at maturity.

Interest

Interest is the charge for the privilege of borrowing money, typically expressed as an annual percentage rate (APR).

Installment Sale

An installment sale is a financing arrangement in which the seller allows the buyer to pay for the goods over an extended period with installments, potentially carrying tax implications.

Amortization

Amortization is the process of gradually paying off a debt over a period in regular installments of principal and interest.

Online References

Suggested Books for Further Studies

“Principles of Corporate Finance” by Richard A. Brealey and Stewart C. Myers
“Fundamentals of Financial Management” by Eugene F. Brigham and Joel F. Houston
“Accounting Principles” by Jerry J. Weygandt, Paul D. Kimmel, and Donald E. Kieso
“Corporate Finance” by Stephen A. Ross, Randolph W. Westerfield, and Jeffrey F. Jaffe

Fundamentals of Principal Amount: Finance Basics Quiz

### What is the principal amount on a loan? - [x] The original sum of money borrowed excluding interest. - [ ] The cost of borrowing money. - [ ] The total interest to be paid over the loan term. - [ ] The fees associated with securing the loan. > **Explanation:** The principal amount on a loan is the original sum of money borrowed, excluding any interest or additional fees. --- ### What is required to be repaid at the maturity of a bond? - [x] The principal amount or face value. - [ ] Only the accrued interest. - [ ] The interest and fees. - [ ] Only the fees charged by the issuer. > **Explanation:** At maturity, the borrower is required to repay the bond's principal amount or face value, apart from any accrued interest. --- ### Is the principal payment on a mortgage tax deductible? - [ ] Yes, always. - [ ] No, it is always taxable. - [ ] Only for second homes. - [x] No, it is not tax deductible. > **Explanation:** Principal payments on a mortgage are not considered tax-deductible. Only the interest portion may be deductible under certain conditions. --- ### Are loan principal repayments considered taxable income? - [ ] Yes, always taxable. - [x] No, they are not taxable income. - [ ] Only if the loan is over a certain amount. - [ ] Depends on the lender. > **Explanation:** Loan principal repayments are not considered taxable income as they merely return the borrowed amount. --- ### What type of sale could make principal receipts taxable? - [ ] Traditional Sale - [ ] Mercantile Sale - [x] Installment Sale - [ ] Bulk Sale > **Explanation:** Principal receipts in an installment sale may be taxable if the sale was reported as such for tax purposes. --- ### How does a principal payment affect the loan balance? - [ ] Increases the loan balance. - [x] Decreases the loan balance. - [ ] Keeps the balance unchanged. - [ ] Doubles the balance. > **Explanation:** Principal payments reduce the outstanding loan balance, lowering the total amount due. --- ### What is 'face value' in relation to bonds? - [ ] The extra amount borrowed. - [ ] The profit earned from the bond. - [x] The original nominal value stated by the issuer. - [ ] The discounted price of the bond. > **Explanation:** The face value is the original nominal value of a bond as stated by the issuer, to be repaid at maturity. --- ### For tax purposes, what is the benefit of an installment sale for the seller? - [ ] Immediate high taxation. - [ ] Avoids repayment of the principal. - [x] Spreads tax liability over time. - [ ] No tax implications. > **Explanation:** An installment sale allows the seller to spread tax liability over time, as the principal receipts in payments may be taxed as they are received. --- ### Which of the following best defines 'interest'? - [ ] The original sum borrowed. - [x] The cost of borrowing money. - [ ] The total loan amount. - [ ] Additional fees and charges. > **Explanation:** Interest is the cost of borrowing money, usually expressed as an annual percentage rate (APR). --- ### How is 'amortization' related to principal payments? - [ ] It increases the principal amount over time. - [x] It is the gradual repayment of the principal and interest over time. - [ ] It only affects the principal amount. - [ ] It keeps the principal amount unchanged. > **Explanation:** Amortization refers to the gradual repayment of both principal and interest through regular installments over time.

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