BANKING

What is Interest?

DEFINITION

Interest represents the cost of borrowing. The lender gets interest and the borrower pays it.

The Key Takeaways

  • Interest is the amount you owe or receive on a loan.
  • Lenders will calculate interest as a percent of the total loan amount.
  • You can earn interest on your money by either lending it (through a bond, certificate of deposit or other similar instrument) or by depositing the funds in an interest bearing bank account.
  • Compound interest is the accumulation of interest over time, as interest payments begin to earn additional interest.

What is the Interest Rate?

Interest is the cost of debt. This situation can affect anyone. You incur debt when you borrow money and have to pay interest. You extend credit to someone else, such as a bank, and receive interest. It is common to quote the amount of money you receive or pay as an annual percentage, but this does not have to be true.

The interest costs will require you to make additional payments on top of your original loan or deposit. You will end up repaying more to a lender than you borrowed. In the opposite direction, interest payments are what make lending profitable.

If you borrow money to buy a vehicle, you will owe both the principal (also known as the “principal”) and the interest charged by your lender. You’ll need to pay back the $10,000 loan plus 6% (or $600) of the $10,000. This will total $10,600. The lender decides how long it will take you to pay back this amount. 1

If you put money into a savings account you will earn interest. You can earn $600 more in interest if you deposit $10,000 into an account with 6% interest. If you save using simple rate, after a year you will have $10,600.

Note:

You can see an example simple interest calculation by using this Google Sheets worksheet. The majority of banks and credit card companies do not use simple interests. Interest compounds instead, leading to interest amounts that increase more rapidly.

Some methods of calculating interest are more advantageous to lenders. The decision of whether to pay interest is based on what you will receive in return. Similarly, the decision to earn an interest is based on your investment options.

Borrowers Pay Interest

You’ll have to pay back the money you borrow. You must repay the money you borrow plus more to compensate for the risk of lending you the money and the inconvenience. Interest rates will increase the more risky you are to the lender and the longer you borrow money.

Interest Payments on Lending

You can deposit your extra funds into a savings account and let the bank invest or lend them out. You can expect to receive interest in exchange. You might feel tempted to just spend your money if you’re not going to make any interest.

Savings accounts are federally insured, so there is no risk and you can withdraw your money whenever you want. Savings accounts have federal insurance, which means there’s no risk and you can withdraw your money at any time. 3 This is why interest rates are lower on savings than other interest bearing options.

 

Do I have to pay interest?

You will usually have to pay interest when you borrow money. It’s possible that you may not realize this, since interest costs are not always included in a separate transaction or bill.

Interest on Installment Debt

Interest costs are included in your monthly payments for loans such as standard auto, student, and home loans. A portion of each monthly payment is used to reduce your debt. The remainder goes towards your interest costs. These loans require you to pay off your debts over a specified time period.

Interest on Revolving Debt

Some loans are revolving, which means you can borrow money month after month while making periodic payments. Credit cards, for example, allow you to make repeated purchases as long as your limit is not exceeded. 5

Interest rates are calculated differently. You can find out more about interest and payments by consulting your loan agreement.

Other Costs Besides Interest

Loans often have an annual percentage rate quoted. This number will tell you the amount you pay each year. It may also include other costs in addition to interest. The interest rate is your pure interest cost (not APR). Closing costs and finance costs are not technically interest costs. They come from your loan amount and interest rate. It would be helpful to know the differences between an interest rate and an APR . An APR is a more useful tool for comparison. 6

 

How do I earn interest?

When you deposit money into an interest bearing bank account such as a saving account or lend money, you earn interest. Banks do your lending when you deposit money into an account. They use the money to make investments and offer loans to customers. Banks pass on a portion their profits to you as interest when they earn money.

The bank will pay interest to your savings periodically (every quarter or month, for instance). The bank will make a payment for interest and your account balance will increase. You can spend the money, or you can keep it to continue earning interest.

You can build up your savings by leaving the interest on your account. You will earn interest both on your initial deposit and on interest added to your bank account. Compound interest is the term used to describe interest that you earn on top of interest previously earned. 7

Note:

Google Sheets Spreadsheet with an example compound interest. Copy the spreadsheet and change it to learn more.

As an example, let’s say you deposit $1,000 into a savings account with a 5% rate of interest. You would earn $50 with simple interest over a year. Calculate:

  1. Divide $1,000 by 5% to get a 5% return.
  2. Earnings of $1,000 divided by.05 equal $50 (see to convert decimals and percentages).
  3. Balance after one year = $1.050

Most banks do not wait until the end of the year to calculate interest. They do it every day. Compounding works in your favor, as you can take advantage. Assuming your bank compounds interest daily:

  • After one year, your account balance will be $1051.27.
  • Your annual percentage yield would be 5.13%.
  • Over the course of the year, you would earn $51.27 as interest.

It may seem like a small difference, but over time it can add up. You’ll get a little more for every $1,000 you deposit. The process snowballs as time goes on and you continue to deposit money. You’ll make $53.89 the next year if you don’t touch the account, up from $51.27 the year before.

 

FAQs (Frequently Asked Questions)

Who pays the interest on a borrowed amount?

The borrower is responsible for paying interest. A lender might offer a promotion that offers 0% interest. This can save the borrower money. The borrower is responsible for paying the interest on any loan.

What is the impact of raising interest rates on inflation?

The cost of borrowing money rises when interest rates increase. Theoretically, this means that fewer businesses and individuals will borrow money, and the overall economy should experience a slowdown. In other words rising interest rates reduce demand. When the demand curve shifts and there is less demand for goods and services, businesses won’t be able to raise prices, and inflation will slow.8

the authorAaron Krause

Leave a Reply