If you’ve ever taken out a loan, used a credit card or even opened a savings account, you’ve experienced the drawbacks or benefits of interest.
Interest represents the money you can earn for letting other people use your money, or the money you pay for using theirs.
For instance, when you put money in a savings account, CD or other investment fund, you are allowing the bank to use your money. The bank or investment firm pays you for keeping your money with them.
When you borrow money from a bank or mortgage lender or when you use a credit card, you are using someone else’s money. In most cases, you’ll pay for that privilege of borrowing money. The interest rates you pay will depend on:
- Your credit score
- The federal interest rate (called the prime interest rate)
- Any special offers lenders have available
How Interest Works
The interest you collect or pay is a percentage of the total amount of money you have in the account or the money you borrowed.
When you pay interest on a loan, you pay a percentage of the total loan amount as interest charges.
With mortgages, car loans and personal loans, the interest charges are added to the total amount of the loan and spread out over the loan terms as part of your monthly payment.
A loan term refers to how long you are allowed to borrow the money before you must pay the loan in full, so a 30-year mortgage would have a loan term of 30 years. Personal loans commonly have terms of two, five or 10 years.
Credit card purchases begin accruing interest charges as soon as the grace period for purchases ends. Credit cards often have grace periods of 25 to 55 days. You can avoid paying interest on your credit card purchase if you pay your card in full before the grace period ends.
However, if you carry a balance on your credit card, you’ll pay interest on new purchases and the existing balance, dating back to the date of purchase. That’s why it’s important to pay your credit card balance in full each month if you can. You could pay hundreds – or even thousands – of dollars in accrued interest charges if you carry a balance on your card.
Why Do You Pay Interest?
Interest is considered the cost of borrowing money. The interest you pay on loans and credit cards helps fund banks, credit card companies and other lenders so they can continue to pay their operating expenses, meet payroll and, of course, turn a profit.
You wouldn’t expect to go to a grocery store and receive your milk, bread and toilet paper for free. Lenders won’t let you use their money for free, either.
Interest charges can also act as a deterrent to borrowing too much money, helping people keep their finances in check. If you know that the flat-screen TV or gaming computer you buy today could cost you an extra $100 in interest over time, you might think twice, wait until you have cash in hand or work to pay off the credit card bill sooner.
How Do You Earn Interest?
Fortunately, interest works both ways. You don’t have to let investment companies and banks use your money for free, either.
You can earn interest by investing money in a number of ways:
- 401(k) accounts
- Certificates of Deposit (CDs)
- Life insurance accounts
- Savings accounts
Whether you’re paying interest charges or earning interest, there are two types of interest you should be aware of.
What Is Simple Interest?
Simple interest is a flat rate based on the total loan amount. Interest charges are calculated from day one, based on the total amount of the loan. Even if you pay the loan back early, you’ll pay the same amount of interest.
And if your money is earning interest, you’d receive the same interest payment unless you decided to add more funds to your total balance. In other words, your interest payments would not earn interest.
Simple interest is most common on car loans and personal loans, which often have relatively short terms.
A simple-interest mortgage loan charges interest daily based on your balance, rather than monthly. When you pay your mortgage, that money first goes toward interest and then toward the principal loan amount.
Whether you pay simple interest or compounding interest, as you continue making payments on your mortgage, you’ll pay more toward the principal because your interest payments will drop. That’s why home buyers often benefit from larger tax write-offs in the earlier years of their mortgage, when they can deduct substantial amounts of interest on their federal taxes, up to $500,000 in mortgage debt for singles and $1 million for married couples, filing jointly, for mortgage debt incurred prior to December 16, 2017.
What Is Compound Interest?
Most credit card companies charge compounding interest, which means that you pay interest on the interest charges you’ve accrued. So, if you make a purchase of $100, and then make a minimum payment of $25 before the grace period ends, you’ll be charged interest on $75. Let’s say you get charged $2 in interest on that $75. The next time your credit card company calculates your interest charges – assuming you don’t use the card again before the next statement – you will be charged interest on $77, not $75.
On the other hand, if you’re looking to invest money, you want to find an account that offers compounding interest.
Compound interest benefits the lender or the investor by multiplying your money rapidly. When your money earns compound interest, you receive an interest payment based on the total amount in your account, not just on your original deposit. Essentially, your interest earns interest.
You can compare interest rates for investments by looking at the APY, or annual percentage yield. This number shows how much interest your investment account will earn over a year. It depends on whether the investment offers simple interest or compounding interest.
If the account compounds the interest, the APY will vary depending on whether interest is compounded daily, monthly or annually. Even if the annual interest rate for two investments looks the same on paper, the money you earn can vary dramatically depending on the compounding interest.
For instance, if you put $10,000 in an account with a percentage rate of 12 percent, you’d earn $1,120 on a simple interest account. This investment has an APY of 12 percent.
If that money is compounded annually, you’d earn $1,200, because you’d earn another 12 percent interest on the $1,120 interest you earned.
But the game changes – favorably – if your interest is compounded monthly. Now, your account earns 1 percent interest each month, so you’ll have $10,100 the first month. Then, you’d earn 1 percent interest on $10,100. At the end of the year, you’d have $11,628.30. The APY for this account would be 12.683 percent.
When It Comes to Interest Rates, Choose Wisely
Remember, compounding interest is good for the lender and bad for the borrower. Simple interest, on the other hand, makes it easier to see the exact cost of borrowing money over a set period of time.
Understanding the difference between compound and simple interest, and how interest works can help you make smarter financial decisions.
Dawn Allcot is a full-time freelance writer, content strategist, and founder of GeekTravelGuide.net, a travel, technology, and entertainment website. A seasoned finance writer, her work has appeared on Forbes, Bankrate, Lending Tree, Solvable, Moneycrashers, and many other personal finance sites, including the award-winning Chase News & Stories portal. With more than 20 years editorial experience, Dawn seeks to take complex concepts and simplify them for today's busy readers. Whether she is writing about taxes or technology, her goal is always to educate, inform, and entertain.