Taking out a loan — whether it’s a home mortgage, a car loan or a simple credit card — is a major financial decision. If not managed carefully, debt and the interest that comes with it can negatively impact your financial health. That’s why understanding interest is essential before borrowing.
When you take out a loan, the principal is the original amount you borrow. The interest is the cost of borrowing that money, and the interest rate is the percentage used to calculate how much interest you’ll pay based on the principal. Below are some additional key concepts you’ll need to know before you take out a loan.
Simple interest is calculated only on the principal amount of a loan. For example, if you borrow $100 at an annual interest rate of 5% for three years, the total amount of interest you will pay is $15 ($100 x 5% x 3).
Compound interest, on the other hand, is calculated on the initial principal and any accumulated interest that hasn’t been paid. This means the total amount owed grows faster over time. A home mortgage is a common example of a compound interest loan.
Fixed interest means the interest rate remains unchanged throughout the loan term. This gives you predictable monthly payments and can make budgeting easier.
Variable interest (also called floating interest) fluctuates over time based on a benchmark rate, such as the prime rate. With variable interest, your monthly payments can increase or decrease over time, so it’s important to understand the risks before committing.
The nominal interest rate is simply the stated interest rate of a loan. For example, a 5% nominal rate on a $100 loan means you’ll pay $5 in interest over one year.
The effective interest rate reflects the actual cost of borrowing by accounting for the impact of compounding interest. Suppose you borrow $100 under the same terms above, but 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%.
The interest rate reflects only the cost of borrowing the principal. In contrast, the annual percentage rate (APR) represents the yearly total cost of borrowing, including interest and fees. For example, if you borrowed $100 at a 5% interest rate with an annual $1 fee, you’d pay $5 in interest and $1 in fees — totaling $6. That results in an APR of 6% ($6 / $100).
Amortization refers to the process of repaying a loan through scheduled, fixed payments that cover both interest and principal. In the early stages of an amortized loan, a larger portion of each payment goes toward interest, while later payments increasingly reduce the principal. Mortgages are a common example of amortized loans, offering predictable payment structures over time.
Accrued interest, on the other hand, is interest that builds up on a loan before it’s paid or added to the balance. This often occurs during periods when payments are deferred — such as with student loans while you’re in school — causing the total amount owed to grow even before repayment begins.
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, providing additional guidance in handling your resources wisely.
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The information in this article is for educational purposes only and is provided with the understanding that GuideStone is not rendering legal, financial or tax advice. We encourage you to consult with appropriate counsel and other advisors on all of your unique financial obligations and requirements.
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• Nov 26, 2025 