Whether you are borrowing money or saving it, interest plays a role. These basics explain what interest is and what it can mean to your financial accounts.
The simplest definition of interest is the cost of using someone else’s money. It can take the form of a charge you have to pay in addition to the original loan amount (principal) when you borrow money, or a reward you earn for allowing a bank or other financial institution to use your money when you deposit funds into an interest-bearing account — a savings account or certificate of deposit (CD), for example.
Interest is calculated as a percentage of the loan or account balance. This percentage is known as the interest rate. Interest rates vary from account to account and financial institution to financial institution, so be sure you understand exactly how much you will be charged — or earn — when you take out a loan or open an interest-bearing deposit account. (Find out more about interest rates.)
It’s also important to know whether the interest rate reflects simple or compound interest. Simple interest is calculated on the principal alone; compound interest is calculated on the principal plus any interest that has accumulated in the account. Compound interest works in your favor in a savings account, because the larger your balance grows through deposits and earned interest, the more interest you get paid. Conversely, compounding can work against you if it’s applied to a revolving credit card account, because monthly interest charges are based on your outstanding balance plus accrued interest. (Learn more about simple and compound interest and how they are calculated.)
How Interest Works When You Borrow
You pay interest when you borrow money by taking out a loan or carrying a credit card balance. You may have to look closely to see exactly what you’re paying in interest.
For installment loans, where you borrow a set amount of money all at once (car loan, student loan, mortgage) and agree to pay off the loan over a specified time period, the interest charge is included in your monthly payment. A certain amount of that payment goes toward paying off your principal; another portion goes toward paying off the loan’s interest. While the monthly payment amount may stay the same over the life of the loan, a higher percentage of it may go toward interest early in the loan’s life, with larger amounts going toward the principal with subsequent payments. You can see how much of your monthly payments go toward interest and principal, respectively, by using an amortization calculator.
It’s especially important to understand how much interest you will pay in total over the life of the loan so that you know the actual price you are paying to borrow that money.
For revolving loans — namely, credit card debt — you have the opportunity to continue “borrowing” (spending) as long as you don’t exceed your credit limit and you make at least your minimum monthly payment. Again, being informed is important, as interest charges can snowball during time periods when you don’t pay off your balance in full.
The interest rate on credit cards is typically variable, meaning it can change from time to time. A credit card may also have multiple interest rates: one for purchases, one for cash advances, temporary promotional rates, etc. Read your credit card terms closely and make sure you understand how much interest you’re paying.
Also make sure you are aware of any fees that may be assessed on your loan or credit card account over and above the interest rate. When terms include an annual percentage rate (APR) rather than an interest rate, it may indicate that you are being charged additional fees. (Learn the difference between APR and interest rate.)
How Interest Works When You Save
The script flips when you allow the bank to use your money, by depositing it into an interest-bearing bank account. The bank is able to make investments and offer loans to other customers using the funds you and other customers have deposited. They then share the revenues they make on those transactions with you in the form of interest.
Depending on the financial institution, interest may be paid on your account monthly, quarterly or at some other frequency. The interest shows up as a transaction on your account statement and increases your balance. As mentioned above, if your bank compounds interest, you can earn interest on your interest as well as on your principal account balance. Over time, interest can help you build your balance and your wealth.