The price of utilizing someone else’s money interests. Interest is paid by the borrower and is received by the lender.

## Definition and Example of Interest

For the right to use the lender’s money, interest is calculated as a percentage of the loan (or deposit) balance and is paid on a regular basis. Although interest can be calculated for periods that are longer or less than one year, the amount is often presented as an annual rate.

In addition to the principal amount of the loan or deposit, interest must also be paid. To put it another way, think about the requirements for borrowing money. More cash is the solution.

For instance, if you take out a loan to purchase a car, you will be responsible for paying both the principal amount of the loan as well as interest, which is the fee the lender assesses you for borrowing the money. If your automobile 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) to the lender, for a total of $10,600. You can be given a long time to repay this loan by your lender.

On the other hand, you can be the one who receives interest if you deposit money in a savings account. If you deposit $10,000 in an account that pays 6% interest, you will keep your $10,000 investment in addition to earning an additional $600 in interest, giving you a total of $10,600.

## How Does Interest Work?

There are numerous methods for calculating interest, some of which are more advantageous for lenders. The decision to earn interest depends on the other possibilities available for investing your money, just as the decision to pay interest depends on what you receive in return.

### When Borrowing

You must pay back whatever money you borrow in order to borrow it. Additionally, you must refund more than you borrowed in order to make up for the lender’s risk in loan to you (and their inability to utilize the money elsewhere while you use it).

### When Lending

If you have excess 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 is little benefit to waiting if you are not going to make anything, so you could be tempted to spend the money instead.

How much interest do you pay or receive? The interest rate will determine it.

The loan’s principal amount

length of time until repayment

The borrower pays more as a result of a higher rate or a loan with a longer duration.

For instance, if you utilize simple interest and a balance of $100, an interest rate of 5% annually results in interest fees of $5 annually. Use the Google Sheets spreadsheet with this example to see the calculation in action. Change the three aforementioned elements to observe how the interest rate varies.

The majority of banks and credit card companies don’t employ simple interest. Instead, because interest compounds, the amount owed grows over time.

## Do I Have to Pay Interest?

You typically have to pay interest when you borrow money. However, since there isn’t usually a line-item transaction or separate bill for interest costs, that might not be clear.

### Installment debt

Your monthly payment includes interest fees for loans like typical home, auto, and education loans. Your monthly payment includes interest costs in addition to a part that goes toward paying down your debt. With those loans, you settle your obligation over a predetermined time frame (a 15-year mortgage or five-year auto loan, for example).

### Revolving debt

Other loans are revolving, which means you can borrow additional money each month and pay it back over time. For instance, credit cards let you make repeated purchases as long as you don’t go over your credit limit.

Calculations of interest can differ. To understand how interest is calculated and how your payments are made, consult your loan agreement.

### Additional costs

Loan quotes frequently include an annual percentage rate (APR). This figure indicates your annual payment and may also reflect expenses other than interest rates. The interest rate is the total cost of borrowing (not the APR). Some loans require you to pay finance charges or closing expenses, which are technically not interest charges but are determined by the size of your loan and your interest rate. Knowing the distinction between an interest rate and an APR would be helpful. An APR is usually a superior tool for comparisons.

## How Do I Earn Interest?

When you lend money or put money into an interest-bearing bank account, like a savings account or a certificate of deposit, you get paid interest (CD). Banks handle all of the lending for you by using your funds to make loans to other customers and other investments, and then they pay you interest on a share of that income.

The bank will periodically pay interest on your savings (every month or every three months, for example). Your account balance will rise, and you’ll see a transaction for the interest payment. You have two options with that money: either spend it or leave it in the account to continue earning interest.

By leaving the interest in your account, your savings can really take off. Both the initial deposit you made and the money that is applied to your account are subject to interest.

“Compound interest” is the practice of earning interest on top of prior interest.

Let’s say, for illustration purposes, that you deposit $1,000 in a savings account with a 5% interest rate. Over the course of a year, simple interest would net you $50. To compute:

- Divide $1,000 in savings by the interest rate of 5%.
- $1000 times.05 equals $50 in earnings (see how to convert percentages and decimals).
- $1,050 will be the account balance after a year.

However, rather than waiting a year, the majority of banks determine your daily interest profits. That benefits you since you use compounding, which is advantageous. Considering that your bank regularly compounds interest:

After a year, you would have $1,051.16 in your account.

Your APY, or annual percentage yield, would be 5.12%.

Over the course of the year, you would make $51.16 in interest.

Although the difference may appear negligible, we are only discussing the first $1,000. You’ll make a little bit more money with every $1,000. The process will continue to snowball into bigger and bigger rewards as time goes on and you make more deposits. If you don’t make any changes to the account, you’ll make $53.78 the next year as opposed to $51.16 the first.

Check out a Google Sheets spreadsheet with a compound interest illustration. To understand more about compound interest, make a copy of the spreadsheet and make adjustments.

### Key Takeaways

- When you borrow money, you either have to pay interest or be rewarded when you give it out.
- The sum is determined as a portion of the loan.
- Lending money or putting money into an interest-bearing bank account will earn you interest.
- “Compound interest” is the practice of earning interest on top of prior interest.