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How Does Interest Work?
When you borrow money, it's important to consider the true cost—interest. Along with repaying the amount you borrowed, you'll also pay interest, which acts as a fee or "rent" for using someone else's money. Borrowing allows you to purchase things you can't afford upfront, with the commitment to pay later. On the other hand, if you lend money, interest serves as your reward for allowing others to use your funds.
The amount of money you initially ask to borrow is called the principal amount. You will be charged interest based on your interest rate (the percentage it costs you to borrow money) and the terms of your debt. When interest starts to accrue (or add up), it will start to increase the amount you owe. While interest can seem daunting especially as it goes up, it can also benefit you. If you deposit money in a savings account, you allow the bank to lend out your money and you will be paid interest on it.
How does Interest Affect Costs?
In the United States, when the demand for goods and services increases, the cost of those goods and services rises, resulting in inflation. Typically, inflation benefits borrowers when borrowing money is inexpensive. However, excessive and rapid inflation can harm the economy. In response, the Federal Reserve, the central banking system of the U.S., may raise interest rates to limit consumer spending. When borrowing becomes more costly, banks pass on those rates to businesses and consumers, causing a decrease in spending. Conversely, when interest rates decrease, businesses and consumers tend to increase their spending.
Interest vs APR
The interest rate is only the cost of borrowing the money and it is influenced by the rate set by the Federal Reserve. Along with interest, many financial institutions such as banks and credit unions will advertise an annual percentage rate (APR), which includes the interest rate as well as any additional costs or fees required such as loan origination fees, certain closing costs, transaction fees, and any other fees your lender includes set by your financial institution. The APR gives you a better idea of how much the loan will cost as a whole.
Types of Interest
As a borrower, you should be aware of some of the different types of interest used in lending. If you are looking to borrow money, the higher the interest rate, the more money you are paying to use that money. A lower interest rate means you are paying less to use the money. If you are being paid interest (such as with a savings account) a high interest rate means you are being paid more to allow the bank to borrow your money. The most common types being simple interest and compound interest. Understanding these two main types of interest will enable you to understand and find the loan or savings account terms that suit you best.
What is Simple Interest?
Finding out the simple interest of a specific amount of money requires you to have your outstanding principal amount, your fixed interest, and the time. Simple interest is based only on your outstanding principal balance.
You can typically find simple interest being used with car loans, student loans, and even on occasion, with mortgages.
What is Compound Interest?
Compound interest is when the interest you earn from prior periods is added back into your principal amount. Then a new interest payment is calculated. This allows the interest to increase for each compounding period.
Compounding interest can be frequently found in long-term investments such as 401(k)s and savings accounts. It’s also common to see compound interest with mortgages and credit cards, so it’s important to talk to your lender about what kind of interest your loan will be accumulating.
How Interest Works with Different Loans
Credit Cards
When it comes to credit cards, you are charged interest, unless you have a 0% APR, on any balance that is unpaid by the monthly due date. Most cards have a period of 21 days where the charges you make are interest free. Many credit card companies compound interest on any carried balances on a daily basis. The outstanding interest is added to your principal at the end of each day. Review your cardmember agreement to find out more about the interest your cardholder may be collecting from you. And remember, credit cards are best paid off each month to help prevent compounded interest payments.
Student Loans
Both federal and private student loans charge interest on your outstanding principal balance . When you pay off your loan, you will have paid off the principal as well as whatever interest the terms included.
Federal student loans these days generally have fixed rates, meaning your interest rate will stay the same over the life of the loan and you will be paying simple daily interest.
Private student loans vary in their terms and rates. While some may use simple daily interest, other private loans may have compound interest. Private student loan lenders will typically offer borrowers fixed or variable interest rate options—meaning, if you borrow a private student loan you will be able to choose either a fixed or variable interest rate.
Variable interest rates may change over the duration of the loan. The interest rate your loan has when it enters repayment may be different that the initial rate at the time when you obtained the loan. These rates may change monthly, quarterly or annually. You should be aware of the high and low interest rates (your interest rate range) you may be paying and be prepared for the possibility of an increase. It is a good idea to calculate both the high and low ends of you interest rate to ensure both payments are affordable to you. Check out our Loan Payment Calculator to find out your repayment options.
Read more about How Student Loan Interest Works
Car Loans
When it comes to car loans, your credit score is one of the biggest factors in determining your car loan interest rate. The higher your credit score, the lower your rate. Auto loans usually calculate their interest based on simple interest. Often your monthly payments will be front loaded, meaning your early payments will be paid more toward interest and less toward your principal balance.
Home Loans (Mortgages)
Home loans are usually determined by simple interest (and if you make your full monthly payment, you pay off the full interest charge). Fixed-rate mortgages are the most popular as the interest rate never changes. This keeps your payments predictable each month. Adjustable Rate Mortgages (ARMs) have come in and out of popularity, depending on the current interest rate. ARMs usually begin with an interest rate lower than the current fixed-rate mortgage and then vary depending on the current interest rate.
Mortgages are typically offered for 15 or 30 years. You may be able to get a lower interest rate for a 15-year term, but your monthly payment may be more than a 30-year mortgage with a higher rate. Check your terms and conditions to find your details and reach out to your lender if you need more information.
