What is Principal Risk associated with?

Principal risk is primarily associated with the possibility that borrowers may face challenges in repaying the principal amount of their loan. Specifically, option C relates to market fluctuations affecting interest-only loans. When borrowers opt for interest-only loans, they typically pay only the interest portion for a set period, which means the principal remains unpaid during that time. If market conditions lead to a decline in property values or an increase in interest rates, borrowers might struggle to refinance or sell their properties without incurring losses. Consequently, this can heighten the risk of not recovering the principal amount, particularly if the property’s market value drops significantly.

By understanding the interaction between market conditions and interest-only loans, one can see how fluctuations can directly impact the repayment capability concerning the principal, leading to heightened principal risk.