What Is Interest and How Does it Work
How Interest Works With Everyday Loans
Interest is the cost of using somebody else’s money. When you borrow money, you pay interest. When you lend money, you earn interest.
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.
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. The amount is usually quoted as an annual rate, but interest can be calculated for periods that are longer or shorter than one year. 1
Interest is additional money that must be repaid — in addition to the original loan balance or deposit. To put it another way, consider the question: What does it take to borrow money? The answer: More 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.
How much do you pay or earn in interest? It depends on:
- The interest rate
- The amount of the loan
- How long it takes to
A higher rate or a longer-term loan results in the borrower paying more.
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.4
Earning interest on top of the interest you earned previously is known as compound interest.
- Multiply $1,000 in savings by five percent interest.
- $1,000 x .05 = $50 in earnings (see how to convert percentages and decimals).
- Account balance after one year = $1,050.
- Your account balance would be $1,051.16 after one year.
- Your annual percentage yield (APY) would be 5.12 percent.
- You would earn $51.16 in interest over the year.
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).
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 interest costs.
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.8 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.