A principal reduction happens in some unique situations where there is too much credit. If the lender gives a $4000 credit, but the total closing costs are $3500, the lender still has to give you that $500 difference. Lenders aren’t able to adjust the loan amount because this could impact your equity. Instead, lenders use that extra $500 as a principal reduction. The lender typically applies the principal reduction within 2-3 months after closing.
So your initial loan amount is still the same and your payments are still based on the initial loan amount. However, shortly after closing, your balance will drop by the amount of the principal reduction. You may be able to pay off your loan slightly sooner. Since you owe less it would also help you if you decide to sell before paying off the loan. The principal reduction shows up as a charge against the borrower since it’s collected at closing.