Interest

Interest is the cost of borrowing money. When you take out a loan or use a credit card, you’ll be required to pay back a specified amount in addition to what you borrowed. That amount is the interest. When you lend money or save money in certain bank accounts, you gain interest.

What is Interest?

Interest is what you owe for borrowing money through a loan, mortgage, or credit card. You can also accrue interest by lending money, or by placing funds in savings accounts. Since you’re basically lending your money to the bank or financial institution, your money will gain interest.[1]

When you borrow money, the lender no longer has access to those funds, and isn’t able to use them or lend them to anyone else. Because of this, the interest you’re charged acts as a fee for the service they’re providing. Your interest payment will most likely be a part of your monthly payment. Depending on the type of loan, part of your payment usually goes toward the principal, and part of it goes toward the interest.

When you place your money in an interest-earning account like a savings account, the bank is able to use your money to lend to other borrowers. In this case, you’re the one lending the money, so your funds will accrue interest, and slowly build over time. How often you receive interest payments will depend on the account and the bank where you’re keeping your money. It may be every month, or every quarter.

How is Interest determined?

Your interest rate is the quantity of interest you are charged (or you earn). There are many different factors that determine interest rates. Your credit score and credit history both affect the type of interest rates you’re offered. Having a better credit score yields better interest rates on things like personal loans, mortgages, and credit cards. At the same time, having a poor credit score and history of missed payments may mean higher rates or not even being able to get a loan or mortgage at all. This is why it’s important to always make timely payments, avoid maxing out credit cards, and avoid taking out loans unless it’s absolutely necessary.[2]

Another factor that affects interest rates, at a higher level, is the government. The Federal Reserve is a government institution that is responsible for regulating the economy and interest rates. They may decide to raise or lower interest rates based on how the economy is performing. This applies to banks and other financial institutions, and is then passed down to businesses and consumers.[3] Having good credit can help you get a lower rate, but if the Federal Reserve decides to raise interest rates, they’ll be raised for everyone regardless of credit score. However, you’ll still be offered a better rate than someone with bad credit.

It’s important when taking out a loan to make sure that you know whether the interest you’re being quoted is monthly, or if it’s the annual percentage rate (APR). APR is the total interest you would pay if you had the loan an entire year. The APR includes all associated fees and charges, whereas the monthly interest may not account for all fees. When a lender tells you the interest rate for a mortgage, auto loan, or personal loan it’s important that they tell you the APR as well as the monthly rate.[4]

Simple vs. compound Interest

There are two basic types of interest that may be applied to a loan: Simple interest and compound interest. Simple interest is a set percentage of the amount that you’re borrowing. For example, if you borrow $100 with a simple interest rate of 10 percent, then you’ll be required to pay back the initial $100, which is the principal, plus $10. Each month that interest is added it will always be based on the principal amount, so in this case you’d accrue $10 every month.

Compound interest is more complicated. This type of interest is charged based on the principal as well as any interest you’ve already accrued. For instance, let’s say you took out the same $100 loan, only this time with a compounding interest rate of 10 percent. So you’ll owe $110 again. But when next month rolls around you’ll accrue another 10 percent, only it will be 10 percent of $110 rather than the principal of $100. Which means the interest you accrue will grow faster than with a simple interest rate. It’s likely that you’ll encounter compound interest rates more often than simple.[5]

Fixed vs. variable rate Interest

Interest rates are also divided between fixed and variable. These terms refer to whether or not the interest rate will change or fluctuate over the course of the loan.

A fixed interest rate is one that will stay exactly the same throughout the life of the loan. So if you get a loan with a 25 percent fixed interest rate, it will remain at 25 percent until the loan is paid in full. A variable interest rate is one that fluctuates based on factors like the economy. Taking out a loan with a variable interest rate of 25 percent means that over the course of the loan you will see increases and decreases in that 25 percent rate.

There are pros and cons to both fixed and variable. With a variable rate it’s likely that the rate will start lower, but it is almost guaranteed to change throughout the life of the loan. There will most likely be a cap on how high it can go, but it may be higher than what you can afford. Going with fixed rate, however, means the rate will be higher than where a variable rate would start, but you have the convenience of knowing it will not change, which means you can plan your finances and budget with more certainty.

Variable rate seems to be more suited for someone who knows they can pay off a loan quickly, this way they can take advantage of the lower rate. However if you’re planning to have the loan for an extended amount of time, you may benefit more from a fixed rate loan.[6]

Why is Interest important?

Interest is important because it can greatly affect how much you pay for life necessities like homes, cars, or appliances. Deciding to buy a home when interest rates are high could mean paying much more in the long run than if you waited until rates were lower. It’s a good idea to have a basic understanding of how interest rates fluctuate and how they affect costs and buying habits.

Interest is also important because it can be higher or lower depending on your specific financial situation. Knowing your credit score, and your credit history means knowing what you can expect in terms of interest rates. The better your credit score, the better interest rates you’ll be offered, and the cheaper it will be to take out loans or mortgages.[3]

References

  1. Pritchard, Justin “What Is Interest? How Interest Works with Everyday Loans” The Balance. August 10, 2016. Accessed September 8, 2016. https://www.thebalance.com/what-is-interest-315436
  2. “How Your Credit Score Affects Your Mortgage” U.S. News Money. March 2, 2011. Accessed September 9, 2016. http://money.usnews.com/money/blogs/my-money/2011/03/02/how-your-credit-score-affects-your-mortgage
  3. “How interest rates are determined” Bankrate. Accessed September 9, 2016. http://www.bankrate.com/finance/cd/how-interest-rates-are-determined.aspx
  4. “Definition of Annual Percentage Rate” RedFin. Accessed September 12, 2016. https://www.redfin.com/definition/APR
  5. “Interest” Investopedia. Accessed September 9, 2016. http://www.investopedia.com/terms/i/interestrate.asp
  6. Lowry, Erin “Fixed or Variable: Which Interest Rate Should You Choose?” U.S. News Money. July 14, 2015. Accessed September 9, 2016. http://money.usnews.com/money/blogs/my-money/2015/07/14/variable-or-fixed-which-interest-rate-should-you-choose