Important conclusions
- Interest is the cash you pay when you borrow or get paid when you lend.
- Lenders determine interest as a percentage of the loan amount.
- By lending money (through a bond or certificate of deposit, for example), or by depositing money into an interest-bearing bank account, consumers can earn interest.
- The term “compound interest” describes how the effects of interest grow over time as interest payments start to earn additional interest payments.
How Does Interest Operate?
Debt comes with an interest charge. Anyone could find themselves on either side of this argument. A loan results in debt accumulation and interest payments. You extend credit and receive interest when you permit someone else to use your funds, such as a bank. The amount you pay or receive is frequently expressed as an annual rate, but it need not be.
In addition to the initial loan balance or deposit, interest charges necessitate additional repayments. You will ultimately pay back more to the lender than you borrowed because of interest. On the other hand, lenders can profit from loans thanks to interest payments.
For example, if you take out a loan to buy a car, you will owe both the principal (also known as the “principal”) and the interest the lender charges. If your car loan is for $10,000 with a 6% interest rate, you’ll have to pay back the $10,000 as well as 6% of $10,000 (or $600), for a total of $10,600. The length of time you have to make this payment will be determined by your lender. 1.
On the other hand, if you place money in a savings account, you will be the one to receive interest. You’ll keep your $10,000 if you deposit it in an account paying 6% interest, plus you’ll make an additional $600 in interest. If you use simple interest, you’ll have $10,600 in your savings account after a year.
Note
Use this Google Sheets spreadsheet to see an illustration of how to calculate interest. The majority of banks and credit card companies do not use simple interest. Instead, because interest compounds, the amount owed grows over time.
Interest can be calculated in a number of different ways, some of which are more advantageous to lenders. The choice to pay interest depends on the benefits you receive in return, and the choice to earn interest depends on your available investment options.
Interest charges for borrowing money
You must pay back any money you borrow in order to borrow it. You must also repay the lender more than you borrowed in order to make up for the risk and inconvenience of lending to you. The lender will view you as being riskier if you borrow money for a longer period of time, which will increase your interest costs.
When lending, interest is paid
If you have extra cash on hand, you can invest it yourself or deposit the money in a savings account, giving the bank the opportunity to lend it out or invest it. You’ll expect to receive interest in return. There may be a temptation to spend the money rather than wait if you aren’t going to make any money.
The interest you earn will vary depending on who you lend money to and how long they intend to use it for, just like the interest you pay on loans. Savings accounts come with federal insurance, so there is no risk and you can practically take money out whenever you want. The interest rates on savings accounts are consequently much lower than those of other interest-bearing instruments.
Should I Pay Interest?
Typically, interest must be paid when borrowing money. However, since there isn’t always a line-item transaction or separate bill for interest costs, that might not be obvious.
Interest on installment loans
The interest costs are included in your monthly payment for loans like typical home, auto, and student loans. Each month, a portion of your payment goes toward reducing your debt, but another portion is your interest cost. With those loans, you make payments over a predetermined time frame (a 15-year mortgage or a five-year auto loan, for example) to reduce your debt.
Interest on rotating debt
Other loans are revolving loans, meaning you can borrow more month after month and make periodic payments on the debt. For example, credit cards allow you to spend repeatedly as long as you stay below your credit limit.
Interest calculations vary. Refer to your loan agreement to figure out how interest is charged and how your payments work.
Additional Costs Aside From Interest
Loans are often quoted with an annual percentage rate (APR). This number tells you how much you pay per year and may include additional costs above and beyond the interest charges. Your pure interest cost is the interest rate (not the APR). With some loans, you pay closing costs or finance costs, which are technically not interest costs that come from the amount of your loan and your interest rate. It would be useful to find out the difference between an interest rate and an APR. For comparison purposes, an APR is usually a better tool.
How Do I Earn Interest?
You earn interest when you lend money or deposit funds into an interest-bearing bank account, such as a savings account. In the case of account deposits, banks do the lending for you; they use your money to offer loans to other customers and make investments. When the banks earn money, they pass a portion of that revenue to you in the form of interest.
Periodically (every month or quarter, for example), the bank pays interest on your savings. You’ll see a transaction for the interest payment, and you’ll notice that your account balance increases. You can either spend that money or keep it in the account so it continues to earn interest.
Your savings can really build momentum when you leave the interest in your account. You’ll earn interest on your original deposit as well as on the interest added to your account. Earning interest on top of the interest you earned previously is known as “compound interest. “.
Note
Check out a Google Sheets spreadsheet with a compound interest example. To gain a better understanding of compound interest, make a copy of the spreadsheet and edit it.
As an illustration, let’s say you deposit $1,000 in a savings account that offers a 5% interest rate. You would earn $50 over the course of a year using simple interest. To figure:.
- Divide a $1,000 savings balance by the interest rate of 5%.
- (See how to convert percentages and decimals.) $1,000 x .05 = $50 in earnings.
- After a year, the account balance is $1,050.
The majority of banks do this daily rather than just once a year, though. You benefit from compounding, so that works in your favor. Assuming your bank compounds interest daily:.
- After a year, your account balance would be $1,051.27.
- It would be 5 point 13 percent for your annual percentage yield (APY).
- Over the course of the year, interest would total $51.27.
Despite appearing slight, the difference adds up. You’ll make a little bit more money for every $1,000. The process will keep snowballing into increasing earnings as time goes on and you make more deposits. If you keep the account open, you will make $53.89 the following year as opposed to $51.27 the first.
Questions and Answers (FAQs)
In relation to loans, who is responsible for paying interest?
Interest on the loan is paid by the borrower. In some circumstances, a lender may provide a 0% interest promotion, saving the borrower money. But the borrower is responsible for paying interest whenever it is assessed on a loan.
How does escalating interest rates fight against inflation?
The cost of borrowing money rises as interest rates rise. Theoretically, as a result, fewer individuals and companies will borrow money, and overall economic growth should be slower. To put it another way, demand is cooled by rising interest rates. Businesses won’t be able to raise prices when the demand curve shifts and there is less demand for goods and services, which will cause inflation to slow.
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