How Does Interest Work?
Interest is the price of debt. Anyone can find themselves on either side of this situation. When you take out a loan, you acquire debt and pay interest. When you let someone else (like a bank) use your money, you extend credit and get paid interest. The amount you pay or receive is typically quoted as an annual rate, but it doesn't have to be.
Interest costs require additional repayments on top of the original loan balance or deposit. Due to interest, you will ultimately repay more than you borrow from a lender. Conversely, interest payments make loans profitable for lenders.
As a simplified 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 charged by the lender. 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 will decide how long you have to repay this amount.
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. After a year, you'll end up with $10,600 in your savings account, assuming you use simple interest.
Use this Google Sheets spreadsheet to see an example of a simple interest calculation. Most banks and credit card issuers do not use simple interest. Instead, interest compounds, resulting in interest amounts that grow more quickly.
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.
Interest Payments When Borrowing
To borrow money, you’ll need to repay what you borrow. In addition, to compensate the lender for the risk and inconvenience of lending to you, you need to repay more than you borrowed. The riskier you are perceived by the lender, and the longer you want to borrow the money, the more interest costs you'll pay.
Interest Payments 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.
Just like the interest you pay on loans, the interest you receive will depend on the riskiness of who you lend to and how long they plan to use your money. Savings accounts are federally insured, so there isn't any risk, and you can essentially withdraw your money whenever you want. That's why the interest rates on savings accounts are much lower than other interest-bearing options.
Do I Have to Pay Interest?
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.
Interest on 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).
Interest on 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 Aside From Interest
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 Interest?
You earn interest when you lend money or deposit funds into an interest-bearing bank account, such as a savings account. In the case of account deposits, banks do the lending for you; they use your money to offer loans to other customers and make investments. When the banks earn money, 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."
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.
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. To calculate:
- 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.
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 it adds up. 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 in the first year.
- Interest is the money you owe when borrowing or receive when lending.
- Lenders calculate interest as a percentage of the loan amount.
- Consumers can earn interest by lending money (such as through a bond or certificate of deposit) or depositing funds into an interest-bearing bank account.
- "Compound interest" refers to how the effects of interest build over time as interest earnings begin earning extra interest payments.
Frequently Asked Questions (FAQs)
Who pays interest on a loan?
The borrower pays interest on the loan. In some cases, a lender may offer a 0% interest promotion, and this saves the borrower money. However, whenever interest is charged on a loan, the borrower will pay those interest costs.
How does raising interest rates help inflation?
When interest rates rise, the cost of borrowing money increases. In theory, that means fewer people and businesses will take out loans, and spending should slow throughout the economy. In other words, rising interest rates cool 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.