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Interest: Definition and Explanation

Dennis Hammer is a writer and finance nerd with six years of investing experience. He writes about personal finance for Wealthsimple. Dennis also manages his own investment portfolio and has funded several businesses in the past. Dennis holds a Bachelor's degree from the University of Connecticut.

Whether you’re taking out a loan or looking for a place to grow your money, you’ll undoubtedly come across interest. This core financial concept is a fundamental part of the entire finance industry. If you understand it well, you’ll save money when you borrow and make money when you deposit.

What is Interest?

Interest is the cost of borrowing money. It’s the amount a lender charges a borrower for the use of its assets. Interest is typically expressed as a percentage of the principal.

What kinds of assets are used as principal? In most cases, we’re talking about cash. When you take out a personal loan, mortgage, or auto loan, a bank lends you cash to make the purchase and charges you interest on the amount they lent. When you put cash in a savings account, the bank pays you interest for lending them your money.

But in some cases, a lender might lend inventory or large assets like property, buildings, or vehicles. They might calculate interest based on the value of those assets or in some other way. For example, a manufacturer might fill a retailer’s shelves without upfront payment, but charge a small interest on the balance of the invoice until it’s paid off.

How Interest Works

When you borrow money, you pay interest. The interest compensates the lender for risking their money by letting you use it. It also compensates the lender for their inability to lend that money elsewhere.

Think of paying interest like paying a rental fee. When you rent a golf cart, you pay the clubhouse for the privilege to use it. That’s the interest. You also have to give back the golf cart. That’s the principal.

Let’s say you borrow £2,000 from a bank. The bank lends you the money for one year and charges 7% interest. After the year, you’ll pay the bank £2,140. The £140 extra is the bank’s compensation for lending you their money. (That’s a simple explanation of how interested is calculated. We’ll explain more in a moment.)

When you lend money, you earn interest. You may not think of yourself as a lender, but you probably are. When you deposit money into a bank account, you are technically lending that money to the bank. You deserve compensation for this. The bank lends that money to its borrowers and charges them interest, gives some of that interest to you, and keeps the difference for themselves.

When you earn interest, that’s your money. You can withdraw it and spend it as you please. Or you can leave it alone to continue to earn more interest. Since interest is paid as a percentage, you can receive more compensation by lending more. That is, you can earn more by sticking more money in your account for the bank to lend out to others.

Annual Percentage Rate (APR)

If you’ve ever shopped for a loan, you’ve probably heard the term APR. APR stands for Annual Percentage Rate. This term includes the interest rate plus any fees that come with the loan. If the loan doesn’t charge any fees, the APR would equal the interest rate. If the loan has fees on top of interest, the APR will be higher than the interest rate.

Why do we bother with APR? Since lenders often charge different kinds of fees on top of interest, it’s hard to compare loans to one another without doing lots of complex math. APR creates a benchmark so you can compare different products.

The History of Interest

People have been charging each other interest as far back as 3,000 BC. Lenders recognized that they needed to be compensated for taking all the risk (the borrower could fail to pay, after all) as well as their loss of the ability to invest that money elsewhere.

During the early days of lending, it wasn’t unusual to see interest rates as high as 20% or 25%. Today, however, rates that high are considered outrageous, even predatory. Historically speaking, interest rates are generally lower today than ever before.

Why are interest rates so low? Competition, mostly. The investment sector is more sophisticated than ever. There are lots of places for investors to grow their money. This means lenders have to increase their interest payouts to attract depositors. It also means they have to decrease their rates to attract borrowers.

Causes of High and Low Interest Rates

Like most things, interest rates are determined by supply and demand. If lenders have a lot of cash to lend (high supply), interest rates fall as they compete with one another. If the supply of loans falls, interest rates go up. Similarly, rates rise when more people want to borrow (high demand) and fall when borrowing slows (low demand).

Inflation is another way interest rates rise. When money inflates, it loses purchasing power. This means the money in your pocket right now it technically worth less over time.

Lenders demand higher interest rates in these circumstances to compensate them for the reduced purchasing power of the money they get back. Think of it like this: You will receive £1 tomorrow, but you expect the value of that dollar to fall to £0.50. Instead, you ask for £2 so you get the same purchasing power back.

The government can also affect interest rates through monetary policy to improve the economy. Central Banks (like the Federal Reserve in the U.S., the Bank of Canada, and the Bank of England) lend money to creditworthy customers, which are mostly other banks. This creates a ripple effect through the economy.

Borrowing banks use the central bank’s interest rate to set the interest rates of their products, like credit cards, mortgages, and auto loans. Low interest rates means money is cheap to borrow, so businesses are incentivized to invest in growth. Higher interest rates cool this effect and make businesses less likely to borrow.

Doesn’t this mean that the central banks should always keep their interest rates low so there’s always economic growth? Not exactly. If interest rates stay low, central banks won’t be able to lower them during an economic downturn in order to boost the economy.

Finally, the individual factors of a loan product and the buyer’s trustworthiness affect interest rates. Lenders charge lower interest on safer bets and higher interest when there’s more risk. Securing a loan with collateral, improving your credit score, and accepting shorter loan terms are good ways to reduce interest rates on loans you take out.

Types of Interest

There are two main types of interest that affect consumers and investors: simple interest and compound interest.

Simple Interest

Simple interest is based only on the principal amount of the loan or deposit. It’s easy to calculate. You simply multiple the principal by the interest rate and the term to determine how much you’ll pay or receive in interest. Auto loans and credit cards are loans with simple interest that most people experience at one point in their life.

Compound Interest

Compound interest is based on the principal of the loan or deposit plus the interest that accumulates on it every period. This means compound interest adds up quickly the longer you owe or are owed money. It’s best to avoid paying compound interest wherever you can, but you should seek to receive compound interest wherever possible.

For instance, when you put money into a high yield savings account, you receive interest each period. When the bank calculates interest at the next period, they’ll calculate it based on your new balance, which means you earn interest on the interest you previously earned.

The snowball effect of compound interest is a key way for you to build wealth over time, and why you should avoid withdrawing from your investment account for as long as possible, especially if you use an automated investment portfolio. For example, reinvesting the returns of a £10,000 deposit (which means just never withdrawing from the account) could earn twice as much over 30 years than if you were to withdraw the gains.

How to Calculate Interest Rates

Before you open an account or take out a loan, it’s always important to calculate how much interest you will pay or earn. This helps you decide if the opportunity is right for you. Here’s how to calculate those two types of interest.

Simple Interest Formula

Simple Interest = (Principal) (Annual Interest Rate) (Term of Loan in Years)

Let’s say Henry takes out a simple-interest loan for £15,000. His annual interest rate is 4% and he repays the loan over six years. You can calculate interest by multiplying the principal by the interest rate (as a decimal) and the loan term.

Total simple interest = £15,000 x 0.04% x 6 + £3,600

Henry will pay £3,600 in total interest on the loan. The total amount paid back will be £18,600.

Compound Interest Formula

Compound Interest = (Principal) (1 + Annual Interest Rate) (Term of Loan in Years) (Principal)

That’s a little confusing, so let’s walk through it. Henry can’t get a simple-interest loan. The bank will lend him his £15,000 at 4%, but they will compound it annually. The loan is still due in six years. You can calculate compound interest rate by adding one to the interest rate (as a decimal), multiplying it by the principal, raising it to the loan term, and then subtracting the principal.

Total compound interest = (£15,000) (1 + .04)^6 - £15,000 = £3,975‬.

In this case, Henry will pay £3,975‬ in total interest on the loan. The total amount paid back will be £18,975‬, which is £375 more than if he had to pay simple interest.

How to Find a Good Interest Rate

Whether you want a low interest rate for a loan or line of credit or a high interest rate on an investment, the best way to find a good rate is to shop around. Compare different products together to get a sense of what the market thinks is fair. Choose the loan or investment that is the best deal for you.

When you shop for a loan or a line of credit, keep your personal circumstances in mind. For instance, if you have bad credit, it’s important to compare offers for people who are in the same credit situation.

Make sure to compare the same kinds of loans together, as well. A 24-month loan will have a different interest rate (and different fees) than a 48-month loan. A home equity loan that uses the house as collateral will offer a more favorable rate than a personal loan that only relies on a promissory note.

When you shop for a savings account or an investment account, simply look for the highest interest rate with terms you can tolerate. For example, a certificate of deposit typically pays more than a standard savings account, but it comes with some unique requirements. Furthermore, make sure to choose a reputable company that insures your money.

Know Your Interest

Never take out a loan, open a line of credit, or open an account without understanding the interest rate. If you don’t know how much lenders charge or pay you in interest, you are probably leaving money on the table. Understanding the interest you pay and earn is an important way to maximize the power of your money.

Last Updated December 5, 2019

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