What does "principal reduction" refer to?

The term "principal reduction" specifically refers to the decrease in the original loan balance as a result of making payments on the loan. When a borrower makes a monthly mortgage payment, a portion of that payment goes toward interest, while another portion reduces the principal amount borrowed. Over time, as more payments are made, the outstanding principal balance decreases, which is what is meant by "principal reduction."

Understanding this concept is crucial because it impacts the overall equity a borrower builds in their property, as a reduction in principal means an increase in the borrower's ownership stake in the property. This terminological understanding is essential for interpreting mortgage agreements and assessing long-term financial commitments in real estate transactions.