What is defined as the principal in finance?

In finance, the term "principal" refers specifically to the amount of money that is borrowed or invested, which serves as the basis for calculating interest. When discussing loans or debt instruments, the principal is the original sum of money that the borrower agrees to repay, not including any interest charges. In this context, it is also the amount upon which future interest calculations are made, thereby determining how much additional money will be paid back over time.

This definition is crucial for understanding how loans function, as the interest applied to the principal determines the overall cost of borrowing. While the total amount of an investment and the annual yield from that investment are related concepts, they do not accurately capture the essence of what "principal" means in this context. The residual value of an asset pertains to its estimated value at the end of its useful life, which is again distinct from the definition of principal in finance. Thus, the second option captures the core definition that applies to various financial discussions involving loans and investments.