What is interest?
TL;DR: Interest is the cost of borrowing money, usually expressed as a percentage. When you borrow, you pay interest to the lender. When you lend, you earn interest. It’s foundational to loans, credit cards, and investments.
Interest is a fee paid by a borrower to a lender for the privilege of using their money. This amount is typically expressed as a percentage of the borrowed amount, called the principal. Understanding how interest works is crucial, as it affects loans, savings, and investments alike.
How Interest Works
When you borrow money, such as through a loan or credit card, the lender charges interest as compensation for the risk they’re taking by lending you the funds. The same is true for investments: when you deposit money in a savings account, the bank pays you interest because, in effect, you’re lending money to the bank.
Types of Interest
- Simple Interest
Calculated only on the principal amount. For example, a $1,000 loan with a 5% annual simple interest rate will cost $50 in interest each year. - Compound Interest
Calculated on both the principal and any accumulated interest. This “interest on interest” effect accelerates growth over time, which is why compound interest is powerful for investments but can be costly with debt.
Why Interest Matters
- For Borrowers: Interest increases the total cost of what you borrow, meaning you pay back more than you initially received.
- For Savers and Investors: Interest is a way to grow your money over time, with compound interest making even small savings grow significantly.
Real-World Applications
- Loans: Mortgages, student loans, and auto loans all come with interest rates that determine the final amount paid.
- Credit Cards: Credit card balances accumulate interest daily if not paid in full each month.
- Savings and Investments: Savings accounts, bonds, and other investments earn interest, helping your money grow over time.
Interest is a fundamental part of financial systems, affecting everything from loans to savings. Understanding how it works can help you make better financial decisions—whether you’re borrowing, saving, or investing.
Disclaimer: The information provided in this post is for general informational purposes only and should not be considered financial advice. Student loan situations can vary significantly based on individual circumstances, and decisions around deferment or forbearance can have lasting financial impacts. Before making any changes to your loan repayment plan, consult a qualified financial advisor or your loan servicer to understand the best options for your unique situation.