What Is Interest – Definition And 4 Amazing Tips

what is interest

Are you searching online for what is interest? We are going to discuss in full and what it entails. Defining interest in a simple way, Interest is the amount of money placed on using another people’s money. You pay interest you borrow money and you earn interest when you lend money.

Here, you will find out everything about interest, including what interest is, how to calculate it and how much you either make or owe depending on whether you borrow or lend money.

What Is Interest?

what is interest

The percentage of the loan (or a deposit) calculated and paid to the lender periodically for the privilege of using their money is called Interest. The amount is generally estimated as a monthly or a yearly rate. However, interest can be calculated for a period that is longer than one year.

Interest is extra money that needs to be paid back in addition to the initial loan deposit or balance.

Let’s reframe this with another question: What does it take to borrow money? The correct answer to this is more money.

How Does Interest Work?

Interest can be calculated in many ways or using many methods, and some methods are more useful for lending institutions. The choice to pay interest depends on what you get in return, and the choice to make interest depends upon the alternative choices offered for investing your money.

Borrowing: When you are borrowing, you will need to repay what you borrow. In addition, to compensate the loan provider for the risk of borrowing you money (and their inability to utilize the money anywhere else while you are using it), you need to pay back more than what you borrowed.

Lending: If extra money is available for you, the money can be put in a savings account, this will allow your bank to invest the money lend it out on your behalf or you can lend the money out yourself. And in return, you’ll be expecting to earn some interest. If you are not going to make anything, you may rather be tempted to spend the money, since there’s little advantage to waiting.

What you earn or pay in interest depending on 3 criteria:

  1. The rates of interest
  2. The loan amount
  3. Duration of repayment

A longer-term loan or higher rate on the money leads to higher repayment from the borrower.

For example, a balance of $100 with an interest rate of 5% per year leads to interest charges of $5 each year, assuming simple interest is used. The simple calculation can be seen using the Google Sheets spreadsheet with this example. If the 3 factors mentioned above is changed, you’ll see how the interest rate changes.

The majority of credit card issuers and banks do not use simple interest, they use compound interest instead so this makes the interest compound and makes the interest amount grows more quickly.

How is interest earned?

what is interest

Interest is earned when you deposit funds in an interest-bearing account, like a savings account or a certificate of deposit (CD), or lend the money out. Banks can do the lending for you by using your money to offer loans to other clients and make other financial investments, a portion of that revenue is paid back to you in form of interest.

Periodically, (monthly or quarterly for instance) the bank pays interest on your savings. A transaction of the interest payment will be seen and you will notice an increase in your account balance.

You can either invest, spend or keep that money in the account so it continues to make higher interest. When you leave the interest in your account; you will make interest both on your initial deposit and the interest added to your account, this makes your savings build momentum very fast.

Making interest on top of the interest you made before is referred to as compound interest.

what is interest

For example: If you deposit $1000 in a savings account that pays a 5% rate of interest. You will make $50 over one year with simple interest. See the calculation below:

  1. Multiply $1,000 in your savings account by 5% interest rate.
  2. $1,000 x 0.05 = $50 in revenues (see how to guide to learn how to convert percentage to decimals).
  3. Account balance after one year = $1,050.

However, your interest is calculated every day by most banks, and not after one year. Due to this fact, this works out in your favor because you take advantage of compounding.

Assuming the interest is compounded by banks:

  1. After one year, your account balance would be $1,051.16.
  2. Your annual percentage yield (APY) would be 5.12%.
  3. You would make $51.16 in interest throughout the year.

Although the difference may appear small, however, we are only discussing your very first $1,000. You will earn more with every $1,000 you deposit. As time goes on, and as you are depositing more money into the account, the process will continue to snowball into bigger and bigger earnings. If the account is left alone, you will earn $53.78 in the second year, compared to the $51.16 you earn in the first year.

See a Google Sheets spreadsheet with this example. You can make a copy of this spreadsheet and make some changes to get more information about compound interest.

When Do I Have To Pay Interest?

You normally have to pay interest when you borrow money. That may not be apparent, as there is not constantly a line-item transaction or different bills for interest expenses.

Installment debt: The interest cost of some basic loans like houses, automobiles, and student loans are baked into your monthly payment. A part of your payment goes towards reducing your debt every month, however, another part is your interest cost. With those loans, you pay for your loan or debt over a particular period (a 15-year home loan or five-year automobile loan, for example).

Revolving loan: Other loans are revolving loans, this simply means you can borrow more month after month and make regular payments on the loan. For instance, credit cards permit you to spend consistently as long as you remain within your credit limit. The calculation of interest varies, however, it is not too difficult to find out how interest is charged and how your payments work.

Extra costs: Loans are typically quoted with an annual percentage rate (APR). This number lets you know how much you pay each year and might consist of extra expenses above and beyond the interest charges. Your pure interest cost is the rate of interest (not the APR).

With some loans, you pay closing costs or finance charges, which is technically not an interest cost that originates from the quantity of your loan and your rate of interest. It would work to discover the difference between interest rates and an APR. For comparison purposes, an APR is typically a much better tool.

Tips on what is interest

  • When borrowing or lending, interest is what you owe or are paid respectively.
  • It is calculated as a percentage of the loan (or deposit) you have actually taken when you owe interest.
  • When you lend money or deposit funds into an interest-bearing bank account, you make interest.
  • Making interest on top of the interest you made before is referred to as compound interest.
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