Whether it’s a home mortgage, a car loan or a simple credit card, taking out a loan is a big decision. Not handling your debt — and the interest that comes with it — can harm your financial well-being. That’s why understanding interest rates is so important. Below are some key concepts you’ll need to know before you take on a loan.
The principle is the original amount of money borrowed.
Interest is the cost you pay to the lender for borrowing money. It’s typically expressed as a percentage (the interest rate) and calculated as a specific dollar amount by multiplying it by the amount borrowed.
Simple interest is calculated only on the principal amount of a loan. For example, if you borrow $1,000 at an annual interest rate of 5% for three years, the total amount of interest you will pay is $150 ($1,000 x 5% x 3).
Compound interest is calculated on the initial principal and any accumulated interest that hasn’t been paid. Compounding increases the total amount owed over time. A home mortgage is an example of a compound interest loan.
Fixed interest means that the interest rate charged will remain the same throughout the loan term. This means that as the borrower, you will pay the loan in fixed installments.
With variable (or floating) interest, the interest rate can fluctuate over time based on an underlying benchmark, such as the prime rate (which is based on the Federal Reserve’s federal funds overnight rate). With variable interest rate debt, your monthly payments could increase or decrease over time, so be aware!
Amortization is the process of spreading out a loan into a series of fixed payments, with a portion of each payment going toward interest and another toward reducing the principal. In the early years of a home mortgage, most of your monthly payment goes toward interest, with a smaller amount going toward the principal. Over time, the portion toward the principal increases while the interest portion decreases.
Accrued interest accumulates on a loan over a period of time before being paid or added to the balance. Student loans are accrued interest loans. While you’re in school, the interest accrues on the principal, but you’re not required to make payments. Upon graduation, the accrued interest is added to the principal balance, increasing your debt.
The annual percentage rate (APR) is the yearly total cost of borrowing, including interest and fees. Suppose you had a $100 loan with an interest rate of 5% and an annual $1 fee. At the end of the year, you would have paid $5 in interest and $1 in fees, totaling $6. This would equal an APR of 6% ($6/100).
The nominal interest rate is simply the stated interest rate of a loan. Suppose you take a loan for $100 at an interest rate of 5%, due at the end of one year. Since the nominal interest rate is 5%, you can expect to pay $5 of interest ($100 x 0.05).
The effective interest rate accounts for the impact of compounding interest. Suppose you borrow $100 under the same terms outlined above, but this time, the interest is compounded semiannually (or twice a year at half the annual interest rate). After the first six months, the interest accrued on your loan is $2.50 ($100 x 0.025). After the second six months, the additional interest accrued on your loan is $2.56 ($102.50 x 0.025). At the end of the loan’s term, you will have paid $5.06 in interest, making the effective interest rate 5.06%, slightly higher than the nominal interest rate.
With all the variations of interest, you can see why it’s essential to understand it to avoid costly mistakes. To minimize your interest expense, remember these two rules of thumb:
Looking for more help? Check out our helpful resources and calculators. Also, browse and watch our webinars for tips on money management and good financial stewardship for additional guidance in handling your financial resources wisely.
At GuideStone®, we want every servant of Christ to finish well. Our mission is to enhance the financial security and resilience for those who serve the Lord.
For more information, contact us at Info@GuideStone.org or 1-888-98-GUIDE (1-888-984-8433) Monday through Friday, 7 a.m. to 6 p.m. CT, to speak with a customer solutions specialist.
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