What is interest? Definition, how it works and examples
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What is interest? Definition
Interest is the price you pay to borrow money or the cost you charge to lend money. Interest is most often reflected as an annual percentage of the amount of a loan. This percentage is known as the interest rate on the loan.
For example, a bank will pay you interest when you deposit your money in a high-yield savings account. The bank pays you to hold and use your money to invest in other transactions. Conversely, if you borrow money to pay for a large expense, the lender will charge you interest on top of the amount you borrowed.
How interest works when borrowing
Whenever you borrow money, you are required to pay that base amount (the principal) back to your lender. In addition, you will be required to pay your lender the interest set for the loan. These loans come in many forms. You may encounter them in the form of credit cards, car loans, mortgages, personal loans and more. Understanding how the interest terms and repayment requirements work is important.
For example, let’s say you borrow $10,000 from your bank in a straightforward loan with a 4 percent interest rate per annum (meaning per year), and the loan is payable in five years. Interest on a typical bank loan is added to monthly payments and is usually compounded monthly. In this example, you’d pay about $1,050 in interest over the life of the loan.
You can use Bankrate’s loan calculator to estimate how much interest you would pay on a loan.
How interest works when lending
Typically, banks use a number of different factors to determine your interest rate, including your credit score and debt-to-income ratio. It also depends on the type of lending, such as a credit card or a home loan. On top of this, commercial lenders usually also charge a separate fee for establishing a loan with a customer.
Let’s say you want to apply for a $5,000 loan from your bank. To establish the interest rate it will charge you, your bank must consider what it pays in interest to get the funds it will lend to you (say, 4 percent). The bank will also have loan servicing costs and overhead it will allocate to your interest rate (say, 2 percent). And of course the bank wants to account for default risk and make some profit (say, another 2 percent). To account for these costs, your loan may carry an interest rate around 8 percent.
The difference between interest and compound interest
There are two basic methods to calculate interest: Simple interest and compound interest.
- Simple interest: With simple interest, your interest rate payments added into your monthly payments, but the interest doesn’t compound. For example, a five-year loan of $1,000 with simple interest of 5 percent per year would require $1,250 over the life of the loan ($1,000 principal and $250 in interest). You’d calculate the interest by multiplying the principal, the APR and the length of the loan: $1,000 x 0.05 x 5.
- Compound interest: This is determined by continually calculating the interest on the principal plus the interest charged for the previous payment period. Compound interest is designed to generate higher returns, at times much higher than simple interest, by compounding the interest earned in the previous terms. If you take out the same loan above but it charges compound interest, you’d pay slightly over $1,332 over the life of the loan ($1,000 principal and $132 in interest).
For large loans with high interest extended over a long term, the increase in total amount paid when interest is compounded can be significant. For this reason, it’s always important to ask your lender or your bank whether a loan or your savings account will have simple or compound interest.