Interest is what a lender charges a borrower for the privilege of using their money. It is usually expressed as a percentage of the principal on an annual basis—the annual percentage rate (APR).
Types of interest
Interest can be calculated in two ways:
- Simple: Interest paid on the original amount borrowed. For example, if you have $1,000 in a savings account that pays a 1.5% rate, you will have $1,015 in the account at the end of the year.
- Compound: Interest paid on both the original borrowed amount and accrued interest. In the previous example, if you kept your savings in that account for a second year, you’d earn 1.5% on both the $1,000 in your account and the $15 you earned in interest. That’s an example of annual compounding, but interest can also compound quarterly, monthly, daily, or continuously, depending on the account or loan. More frequent compounding means more total interest.
Interest rates can also be set in two different ways:
- Fixed: A fixed interest rate stays the same for the life of the loan. Most federal student loans charge fixed rates.
- Variable: A variable, or “floating,” rate can change in response to economic conditions. Some private student loans charge variable rates.
Times when you pay or receive interest
Chances are that you’ll both pay and receive interest at different points in your life. Some situations in which you might be on one end or another of the interest equation include:
|Receive interest||Pay interest|
|Keeping money in a savings account||Carrying a balance on a credit card|
|Keeping money in a CD or money market account||Taking out a mortgage or home equity loan|
|Investing in bonds||Taking out student loans or car loans|
|Making a loan through peer-to-peer lending
or to someone you know
|Paying for goods or services on an installment plan|
Using interest wisely
Here are a few tips to keep in mind if you’re on the receiving end of interest:
- A higher rate translates to more income if you’re receiving interest, so search for the best rate you can find.
- Although savings account rates are very low—the recent average was 0.07%—it’s possible to find rates closer to 1% to 2%.
- Compounding is your friend when you receive interest. Reinvesting the interest you receive will help your money grow.
When you’re paying interest, the opposite is generally true:
- When you borrow money, a higher rate increases the cost you pay, so shop around for the lowest rate you can find and try to pay down high-rate debt first.
- Although a variable interest rate may be lower than a fixed-rate option when you first take out a loan, that rate can change. There’s no certainty of how much total interest you will pay with a variable-rate loan.
- Compounding is your enemy when you’re the borrower. Try to pay off your credit card in full each month so that you don’t start accruing interest on interest.
What affects interest rates
Many factors affect the overall level of interest rates in the economy as well as the particular interest rate charged on a given loan:
- How long the loan is for
- Longer loan term → higher rate
- Credit risk of the borrower
- Riskier borrower → higher rate
- Whether or not the loan is secured
- Unsecured loan → higher rate
- Opportunity cost to the borrower
- Higher cost → higher rate
- Inflation rate
- Higher inflation → higher rates
- Strength of the economy
- Stronger economy → higher rates
The rule of 72
If you’re receiving interest, you can find out roughly when your money will double by using the rule of 72. To do that, divide the number 72 by your interest rate.
Suppose you make an investment that pays a 10% interest rate. Using this rule, your money will double in roughly:
72 / 10 = 7.2 years
There will probably be many different points in your life when you pay or receive interest. Using interest wisely can help you make sure you get the most income you can when you receive interest and pay as little as possible when you’re the borrower.
- Islamic law prohibits paying or receiving interest. If you open a savings account with a Sharia-compliant bank, you may be offered a “target profit” instead of an interest rate.
- In Europe and Japan in recent years, interest rates have turned negative—meaning banks charge a rate for the privilege of holding onto savers’ money—due to government policies.
- In California, a 14-day payday loan has an average interest rate of 459%.
- There is a long history of lenders trying to charge sky-high interest rates and regulators trying to rein them in. The Code of Hammurabi, from about 1750 B.C., limited interest rates on loans of grain and silver.
- Interest benefits the lender and costs the borrower.
- Compound interest means earning interest on top of interest (or if you’re the borrower, paying interest on top of interest).
- Shopping around for the highest rate and letting your money compound can help you earn the most when you receive interest.
- Finding the lowest available rate, avoiding letting interest compound, and being careful of variable rates can help you pay the least when you borrow money.
- Interest rates can be affected by the riskiness of an individual borrower, the length of a loan, and the overall strength of the economy.
- Divide the number 72 by your interest rate to figure out the number of years it will take your money to double.
Interest is the cost of borrowing money or the amount you earn for lending. Interest may be simple or compounded, and interest rates may be fixed or variable. When borrowing money, you can minimize the total amount of interest you’ll pay by seeking a low interest rate. On the other hand, finding a high rate can boost your total income when you invest or lend money.