What Is Interest?

How Interest Works With Everyday Loans

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Interest is the cost of using somebody else’s money. When you borrow money, you pay interest. When you lend money, you earn interest.

What is 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.

A question might help you get a handle on how interest works: what does it take to borrow money? The answer: more money.

When borrowing: In order 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 had 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 it in a savings account and let the bank lend it out. In exchange, you’ll expect to earn interest – otherwise, you might be tempted to spend the money today because there’s little benefit to waiting (other than planning for your future).

How much do you pay or earn in interest? It depends on the interest rate, which is usually quoted as a percentage rate per year. A higher rate means the borrower pays more. For example, an interest rate of 10% per year and a balance of $100 results in interest charges of $10 per year assuming you use simple interest.

Most banks and credit card issuers do not use simple interest – instead, interest compounds (see below).

Earning Interest

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.

Periodically, (every month or quarter, for example) the bank pays interest on your savings. You’ll see your account balance go up, and 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 start earning interest on that money as well as on your original deposit.

Earning interest on top of interest you earned previously is known as compound interest.

Example: You deposit $100 in a savings account that pays a 3% interest rate. With simple interest, you’d earn $3 over one year. To calculate:

  1. Multiply $100 in savings by 3% interest
  2. $100 x .03 = $3 in earnings (see how to convert percentages and decimals)
  3. Account balance after one year = $103

However, most banks calculate your interest earnings every day – not just after one year. This works out in your favor because you take advantage of compounding. Assuming your bank compounds interest daily:

The difference might seem small, but we’re only talking about your first $100 (which is a nice start, but it’s not a big enough savings account to bail you out of trouble).

For every $100, you’ll earn a bit more. Over time (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 $3.14 in the following year (compared to $3.05 the first year).

Paying Interest

When you borrow money, you generally have to pay interest. But that might not be obvious – there’s not always a line-item transaction or separate bill for your interest costs.

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 towards 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 5-year auto loan, for example). To understand how these loans work, read about loan amortization.

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 continuously as long as you stay below your credit limit. Interest complications vary, but it’s not too hard to calculate how interest is charged and how your payments work.

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.