What Is Interest?/ How Does Interest Work?/ Do I Have to Pay Interest?
Interest is the monetary charge for the privilege of borrowing money, typically expressed as an annual percentage rate (APR). Interest is the amount of money a lender or financial institution receives for lending out money. When you borrow money, interest is the cost of doing so and is typically expressed as an annual percentage of the loan (or amount of credit card borrowing). When you save money it is the rate your bank or building society will pay you to borrow your money. The money you earn on your savings is also called interest.
Interest is defined as the amount of money paid for the use of someone else’s money. An example of interest is the $20 that was earned this year on your savings account. An example of interest is the $2000 you paid in interest this year on your home loan.
In accounting, interest refers to the cost of money borrowed from a lender. Usually, a percentage of the principal amount borrowed, interest can be either simple or compound. Invoicing and accounting software makes it easy to track your expenses from anywhere.
Interests are subjects that fascinate you and want to learn more about. Interests are usually more about learning and discovering ideas, concepts, and knowledge like history, animal behavior, or even pop culture. For example, if your interest is history, going to museums would be your hobby.
What Is Interest?
In finance and economics, interest is payment from a borrower or deposit-taking financial institution to a lender or depositor of an amount above repayment of the principal sum (that is, the amount borrowed), at a particular rate. It is distinct from a fee that the borrower may pay the lender or some third party. It is also distinct from dividend which is paid by a company to its shareholders (owners) from its profit or reserve, but not at a particular rate decided beforehand, rather on a pro-rata basis as a share in the reward gained by risk-taking entrepreneurs when the revenue earned exceeds the total costs.
For example, a customer would usually pay interest to borrow from a bank, so they pay the bank an amount that is more than the amount they borrowed, or a customer may earn interest on their savings, and so they may withdraw more than they originally deposited. In the case of savings, the customer is the lender, and the bank plays the role of the borrower.
Good differs from profit
It’s differs from profit, in that interest is received by a lender, whereas profit is received by the owner of an asset, investment, or enterprise. (Interest may be part of the whole of the profit on an investment, but the two concepts are distinct from each other from an accounting perspective.) The rate of interest is equal to the interest amount paid or received over a particular period divided by the principal sum borrowed or lent.
Compound interest means that interest is earned on prior interest in addition to the principal. Due to compounding, the total amount of debt grows exponentially, and its mathematical study led to the discovery of the number e. In practice, interest is most often calculated on a daily, monthly, or yearly basis, and its impact is influenced greatly by its compounding rate.
Two main types of interest can be applied to loans—simple and compound. Simple interest is a set rate on the principle originally lent to the borrower that the borrower has to pay for the ability to use the money. Compound interest is interest on both the principle and the compounding interest paid on that loan. The latter of the two types of interest is the most common.
It is the monetary charge for the privilege of borrowing money, typically expressed as an annual percentage rate (APR). Interest is the amount of money a lender or financial institution receives for lending out money. Interest can also refer to the amount of ownership a stockholder has in a company, usually expressed as a percentage.
Some of the considerations that go into calculating the type of welfare and the amount a lender will charge a borrower include:
- Opportunity cost or the cost of the inability of the lender to use the money they’re lending out
- Amount of expected inflation
- The risk that the lender is unable to pay the loan back because of default
- Length of time that the money is being lent
- Possibility of government intervention on interest rates
- Liquidity of the loan
Definition and Example of Interest
Interest is calculated as a percentage of a loan (or deposit) balance, paid to the lender periodically for the privilege of using their money. The amount is usually quoted as an annual rate, but interest can be calculated for periods that are longer or shorter than one year.
As an example, if you take out a loan to buy a car, you’ll owe the amount of the loan (also called the “principal”), plus the interest, which is the cost the lender charges you for borrowing. If your car loan is for $10,000 at 6% interest, you’ll have to repay the $10,000, as well as pay the lender 6% of $10,000 (which is $600), for a total of $10,600 altogether. Your lender might give you many months to repay this loan.
On the other hand, if you deposit money in a savings account, you can be the one who earns interest. If you deposit $10,000 in an account that earns 6% interest, you’ll not only keep your $10,000, but you’ll earn an additional $600 in interest, too, so you’ll end up with $10,600 altogether.
How Does It Work?
There are several different ways to calculate interest, and some methods are more beneficial for lenders. The decision to pay interest depends on what you get in return, and the decision to earn interest depends on the alternative options available for investing your money.
- When Borrowing: To borrow money, you’ll need to repay what you borrow. In addition, to compensate the lender for the risk of lending to you (and their inability to use the money anywhere else while you use it), you need to repay more than you borrowed.
- When Lending: If you have extra money available, you can lend it out yourself or deposit the funds in a savings account, effectively letting the bank lend it out or invest the funds. In exchange, you’ll expect to earn interest. If you are not going to earn anything, you might be tempted to spend the money instead, because there’s little benefit to waiting.
Do I Have to Pay?
When you borrow money, you generally have to pay interest. That might not be obvious, though, as there’s not always a line-item transaction or separate bill for interest costs.
- Installment debt: With loans like standard home, auto, and student loans, the interest costs are baked into your monthly payment. Each month, a portion of your payment goes toward reducing your debt, but another portion is your interest cost. With those loans, you pay down your debt over a specific time period (a 15-year mortgage or five-year auto loan, for example).
- Revolving debt: Other loans are revolving loans, meaning you can borrow more month after month and make periodic payments on the debt. For example, credit cards allow you to spend repeatedly as long as you stay below your credit limit. Interest calculations vary. Refer to your loan agreement to figure out how interest is charged and how your payments work.
- Additional costs: Loans are often quoted with an annual percentage rate (APR). This number tells you how much you pay per year and may include additional costs above and beyond the interest charges. Your pure interest cost is the interest rate (not the APR). With some loans, you pay closing costs or finance costs, which are technically not interest costs that come from the amount of your loan and your interest rate. It would be useful to find out the difference between an interest rate and an APR. For comparison purposes, an APR is usually a better tool.
How Do I Earn?
You earn interest when you lend money or deposit funds into an interest-bearing bank account such as a savings account or a certificate of deposit (CD). Banks do the lending for you: They use your money to offer loans to other customers and make other investments, and they pass a portion of that revenue to you in the form of interest.
Periodically (every month or quarter, for example), the bank pays interest on your savings. You’ll see a transaction for the interest payment, and you’ll notice that your account balance increases. You can either spend that money or keep it in the account so it continues to earn interest. Your savings can really build momentum when you leave the interest in your account. You’ll earn interest on your original deposit as well as on the interest added to your account.
Earning interest on top of the interest you earned previously is known as “compound interest.”
For example, suppose you deposit $1,000 in a savings account that pays a 5% interest rate. With simple interest, you’d earn $50 over one year.
- Multiply $1,000 in savings by 5% interest.
- $1,000 x .05 = $50 in earnings (see how to convert percentages and decimals).
- Account balance after one year = $1,050.
Most banks calculate
However, most banks calculate your interest earnings every day, not just after one year. That works out in your favor because you take advantage of compounding. Assuming your bank compounds interest daily:
- Your account balance would be $1,051.16 after one year.
- Your annual percentage yield (APY) would be 5.12%.
- You would earn $51.16 in interest over the year.
The difference might seem small, but we’re only talking about your first $1,000. With every $1,000, you’ll earn a bit more. As time passes, and as you deposit more, the process will continue to snowball into bigger and bigger earnings. If you leave the account alone, you’ll earn $53.78 in the following year, compared to $51.16 the first year.
See a Google Sheets spreadsheet with an example of compound interest. Make a copy of the spreadsheet, and make changes to learn more about compound interest.
However, low-interest rates aren’t always ideal. A high-interest rate typically tells us that the economy is strong and doing well. In a low-interest-rate environment, there are lower returns on investments and in savings accounts, and of course, an increase in debt which could mean more of a chance of default when rates go back up.
However, if there is anything you think we are missing. Don’t hesitate to inform us by dropping your advice in the comment section.
Either way, let me know by leaving a comment below!
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