It refers to the original sum of money borrowed in a mortgage, excluding interest and any other charges. Understanding the concept of principal is crucial for both novice and seasoned investors, as it directly impacts investment strategies, mortgage payments, and overall financial planning. This article demystifies the term “principal” and walks you through a comprehensive example to illustrate its practical implications in real estate transactions.
What is Principal?
At its core, the principal is the backbone of any real estate financing agreement. It represents the amount of money that a borrower agrees to repay the lender over the term of the loan, not including the interest. In the context of real estate, this sum typically covers the bulk of the property’s purchase price, after accounting for the down payment.
Key Points:
- Principal Amount: The total amount borrowed or still owed on a loan, without interest.
- Mortgage Payments: Monthly payments that gradually reduce the principal amount, alongside paying off the interest.
How Principal Affects Real Estate Investments
The principal amount has a direct influence on several aspects of real estate investments:
- Mortgage Payments: The size of the principal determines the size of the monthly mortgage payments. A larger principal requires higher payments, while a smaller principal results in lower payments.
- Interest Costs: The interest on a mortgage is calculated based on the principal. Reducing the principal faster can significantly lower the total interest paid over the life of the loan.
- Equity Building: As the principal is paid down, the investor’s equity in the property increases. This equity can be leveraged for further investments or accessed through refinancing.
Here’s how it works:
Let’s break down a hypothetical scenario to illustrate how the principal works in a Canadian real estate investment:
The Initial Purchase
- Property Value: $500,000
- Down Payment: $100,000 (20% of the property value)
- Mortgage Required: $400,000 (This becomes the principal)
Securing a Mortgage
- Term: 25 years
- Interest Rate: 3% annually
Monthly Payments
Using a standard mortgage calculator, the monthly payment for this principal at a 3% interest rate over 25 years is approximately $1,897. This payment includes both the interest and a portion that goes towards reducing the principal.
Over the Years
As the investor makes monthly payments, the portion that applies to the principal increases, while the interest portion decreases. This is due to the reducing balance on which the interest is calculated.
Example Milestones
- After 5 Years: The principal is reduced to approximately $346,000.
- After 10 Years: The principal stands at roughly $286,000.
- Final Payment: The property is fully paid off, and the principal reaches $0.
Equity and Refinancing
After 10 years, the investor decides to leverage the built-up equity (the original $100,000 down payment plus the amount of principal paid off, totaling over $214,000) to invest in another property. This strategy allows the investor to expand their portfolio using the equity from the initial investment.
Conclusion
Understanding the principal in Canadian real estate investments is essential for effective financial planning and investment strategy development. By grasping how the principal amount affects mortgage payments, interest costs, and equity building, investors can make informed decisions that align with their financial goals. The above scenario underscores the importance of principal considerations in real estate transactions, offering a clear roadmap from the initial purchase to leveraging equity for future investments.