What is Interest, and How Do Different Types of Interest Work?
Whether you’re signing up for a credit card, checking your retirement investments, or signing a new home loan, chances are you’re going to come across the term “interest” somewhere in the paperwork.
Put most simply, interest is a charge that is accrued for borrowing money from another person or entity. If you borrow money, you pay interest on the borrowed money. If you allow someone else to borrow money from you, they may pay interest to you on the money you’ve loaned them.
However, there are also positive and negative forms of interest, as well as a couple different types of interest payments. Understanding interest is vital to budgeting and staying fiscally responsible with your money and credit, so let’s dive in and find out about the finer points of interest and how it can affect your finances.
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What Does Interest Mean?
Again, interest is a charge that is often accumulated when borrowing money. If you are the borrower, you can expect to pay interest (which is a percentage and can increase over time) on the money you’ve borrowed. If you are a lender, you can expect to be paid interest back as the money is being returned from a borrower.
Most commonly, interest is associated with bank loans, such as credit cards, home loans, car loans, and more. Interest is accrued as the borrower continues to pay off these large sums of money that they’ve borrowed from the bank, and this helps the bank run their daily operations. Interest in these cases is typically conveyed as an “annual percentage rate” or APR.
However, interest can also be applied to stock accounts, savings accounts, and other investments in where interest is accrued and given back to the owner of the account. In these circumstances, interest is known as “earned interest,” which will be discussed more below.
In the most basic sense, interest is defined as a payment made to the lender by the borrower for a loan.
This form of interest is most commonly associated with savings accounts or stock accounts. In these cases, the borrower is actually the bank, as they use the money a customer deposits in their savings account to either invest it on behalf of the customer, or use it to offer loans to other customers. As the bank collects revenue, they will provide a portion of that (in the form of interest) back to the customer holding the savings account.
Consequently, customers may see their savings account increase in small amounts over time. Banks typically make interest payments on a monthly or quarterly basis. Customers can then decide to keep the money as is in the account, or use it for themselves.
In these cases, keeping money for an extended amount of time in a savings or investment account can often be very beneficial. The longer the money stays in, the higher the interest payments can get, and the interest will begin to compound on itself. A useful analogy for understanding compound interest is the “snowball effect”: the more it collects, the bigger it gets. Compound interest will be discussed more below.
However, when borrowing money from a bank or lender, customers may be paying interest on the money they borrowed. Interest payments are often lumped into the overall monthly payments for loans or debt, and they may not be noticeable as they are not listed as a “line item” on many bills.
To understand how paying interest works, it’s easiest to break it up by the two most common types of debt:
Installment debt is typically loans that are a lump sum, and the customer has agreed to pay down that loan over a period of time (typically years). Home loans (15 or 30 year), car loans, and student loans are a common example. Interest for these types of debt are then rolled into the overall monthly payments made on the lump sum of borrowed money. When a customer agrees to the bank’s or lender’s terms, they also agree on the interest amount. A common example of interest payments being lumped in with overall payments is the PITI payment on a mortgage.
Other types of loans are revolving, meaning customers can continually take out money, pay it off, and take out money again — as the customer needs it. Credit cards are the most common example of this. For these cases, interest charges vary depending on the “cardholder’s agreement” and the customer’s standing with the lender (such as previous payment histories, credit score, and more). The percentage of interest is then charged based on the purchases made and the overall statement amount.
When checking your monthly credit card statements, you may come across a charge labeled “Interest Payment/Charge” (or similarly labeled) which is the amount of interest you have been charged for that month.
Simple Interest vs. Compound Interest
Interest can also come in two different forms: simple or compounding. Below is more information on each form, as well as a formula on how to calculate interest.
How Does Simple Interest Work?
Simple interest is calculated based on the initial amount of an investment or loan. It does not take into consideration the accrual of new debt or earning, as that is compound interest. Simple interest has a basic formula that can be easy to remember.
- P = Principal (the initial amount of the investment or loan)
- r = Interest rate (or APR) as a decimal (ex: 5% = .05)
- t = time (must be in years; months can be used as a fraction of a year)
The formula is then:
- (P) x (r) x (t) = Interest
As an example, if you place $100 in your savings account (P), with an APR of five percent (r), you’ll gain exactly $5 at the end of the year (t) (as long as you don’t take out the initial $100).
Most commonly, simple interest is used for auto loans and short term loans, and some types of mortgages.
How Does Compound Interest Work?
As explained above, compound interest can be likened to the “snowball effect.” As time goes on, the interest on a loan or investment will begin to collect, and then the collected amount of interest will also start to accrue interest. This can lead to exponential growth, as accounts will continue to increase in size — which can be beneficial for the lender, but troublesome for the borrower.
Using the same example above for simple interest, where the customer gains $5 after a year, compound interest would then be the accrual of interest on the $5 earned, plus the $100 principal. After a second year, the account would gain an additional $5.25, and the amount would continue to increase exponentially as time went on.
Compound interest is common with many loans, including mortgages and some credit cards. Additionally, compounding interest is common with savings accounts, stocks and bonds, and other forms of investments.
If, as a borrower, you want to minimize the amount of money you pay your lender through compounding interest, one of the best ways to do this is to pay off your loan or credit card early or fast, so as to slow down the growth of compounding interest.
However, if you’re trying to grow your savings, keeping your money in a savings account with compounding interest can be extremely beneficial as you watch that amount grow over time.
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Katie McBeth is a researcher and writer out of Boise, ID, with experience in marketing for small businesses and management. Her favorite subject of study is millennials, and she has been featured on Fortune Magazine and the Quiet Revolution. She researches SEO strategies during the day, and freelances at night. You can follow her writing adventures on Instagram or Twitter: @ktmcbeth