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Interest is the price you pay to borrow money or the return earned on an investment. For borrowers, 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 investors or savers, interest comes in the form of an annual percentage yield (APY).
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, which is typically an annual percentage of the principal, 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 10 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 $2,748.23 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 lenders determine interest rates
Typically, banks use a number of different factors to determine your interest rate, including your credit score and debt-to-income ratio, which signal the risk of lending to you. 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 annual percentage rate (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.
Interest vs. APY
If you’re an investor or saver, understanding APYs — the compounded interest that a financial institution pays you on savings and investments — can help you grow your wealth over time. When you open a savings vehicle, like a savings account or certificate of deposit, the listed APY tells you how much you will earn over a year.
For example, suppose you have a savings account with an APY of 5 percent. That APY accounts for the simple interest rate and the additional interest due to monthly compounding earned in a year. If you had $10,000 in the account, you’d earn $500 in interest after one year.
Bottom line
Interest is a fundamental concept to personal finance. It has a considerable impact on our personal finance decisions, including saving, investing and borrowing. Understanding how interest works, as well as the distinction between simple and compound interest, can help you make informed decisions about how you borrow and save.
— Bankrate’s René Bennett contributed to an update of this story.
FAQs
For investors or savers, interest comes in the form of an annual percentage yield (APY). 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.
What is interest and how does it work? ›
Key Takeaways. Interest is the monetary charge for borrowing money—generally expressed as a percentage, such as an annual percentage rate (APR). Interest may be earned by lenders for the use of their funds or paid by borrowers for the use of those funds.
What is simple interest easy definition? ›
What Is Simple Interest? Simple interest is an interest charge that borrowers pay lenders for a loan. It is calculated using the principal only and does not include compounding interest. Simple interest relates not just to certain loans. It's also the type of interest that banks pay customers on their savings accounts.
What best defines interest? ›
: a charge for borrowed money generally a percentage of the amount borrowed. b. : the profit in goods or money that is made on invested capital. c. : an excess above what is due or expected.
How can interest work for you? ›
But interest can also work for you when you're the one lending money. Consider a savings account, for example. When you put money into a savings account, your bank lends that money out to other customers. In exchange for using your money, the bank pays you interest.
How does interest only work? ›
For a set period (for example, five years), you pay nothing off the amount borrowed, so it doesn't reduce. At the end of the interest-only period, the loan will change to a 'principal and interest' loan. You'll start repaying the amount borrowed, as well as interest on that amount.
What is the best answer that defines the meaning of interest? ›
Interest is the price you pay to borrow money or the return earned on an investment. For borrowers, interest is most often reflected as an annual percentage of the amount of a loan.
What is simple interest answers? ›
Simple interest is calculated with the following formula: S.I. = (P × R × T)/100, where P = Principal, R = Rate of Interest in % per annum, and T = Time, usually calculated as the number of years. The rate of interest is in percentage R% (and is to be written as R/100, thus 100 in the formula).
What is simple interest easy examples? ›
Simple Interest (S.I.) is the method of calculating the interest amount for a particular principal amount of money at some rate of interest. For example, when a person takes a loan of Rs. 5000, at a rate of 10 p.a. for two years, the person's interest for two years will be S.I. on the borrowed money.
How to explain simple interest to a child? ›
When the fee charged for borrowing money is a fixed yearly percentage of the amount borrowed, it is called simple interest. The amount borrowed is called the principal, or the present value of the transaction. The amount owed at the end of the lending period is known as the future value of the principal.
interest noun (INVOLVEMENT)
the feeling of wanting to give your attention to something or of wanting to be involved with and to discover more about something: I've always had an interest in astronomy.
What is the definition of in your interest? ›
For one's benefit or advantage, as in It's obviously in their interest to increase profits, or Is this policy in the interest of the townspeople? or I suspect it's in your own best interest to quit now. [ Early 1700s]
Is interest good or bad? ›
Interest rates can be seen as 'good' or 'bad' depending on your perspective. For borrowers, lower rates are generally better. They make loans more affordable. For savers and investors, higher rates are usually more desirable.
What is interest explained? ›
Interest is essentially a charge to the borrower for the use of an asset. Assets borrowed can include cash, consumer goods, vehicles, and property. Because of this, an interest rate can be thought of as the "cost of money"—higher interest rates make borrowing the same amount of money more expensive.
How does simple interest work? ›
A simple interest loan is a non-compounded loan. This means that your interest is calculated off the remaining principal balance of your loan, so that you pay a set monthly amount plus interest. If you can manage to pay more on this set amount, it will lower your payments going forward.
How does interest help you? ›
It would help reduce the total amount you have to pay back over time and help you get to financial independence sooner. Remember, you can also take advantage of interest rates to boost your savings. Talk to your banker about solutions like Certificate of Deposits, or Money Market accounts.
How does interest on your money work? ›
Simple interest is expressed in annual percentage yield (APY) and is calculated based on your principal balance (the amount you deposit in the savings account). For example, if you put $10,000 into a savings account with a 1% APY, you would earn interest of $100 annually (1% of $10,000).
Is it better to receive interest monthly or annually? ›
However, savings accounts that pay interest annually typically offer more competitive interest rates because of the effect of compounded interest. In simple terms, rather than being paid out monthly, annual interest can accumulate over the year, potentially leading to higher returns on the sum you've invested.
How is interest paid out? ›
It depends on your account. With most savings accounts and money market accounts, you'll earn interest every day, but interest is typically paid to the account monthly. However, CDs usually pay you at the end of the specific term, but there may be options to receive interest payments every month or twice a year.
What is interest rate in simple terms? ›
An interest rate is the cost you pay to the lender for borrowing money to finance your loan, on top of the loan amount or your principal. The higher the interest rate, the more you'll pay over the life of your loan.
