What Is Interest?
Interest is the monetary cost associated with borrowing money. It is usually specified as an annual percentage rate (APR) and serves as compensation for lenders. Besides its traditional usage, interest also measures the percentage ownership shareholders possess in a company.
Key Takeaways
Interest is the charge for borrowing money—commonly expressed as an annual percentage rate (APR).
- It can be income for lenders or an expense for borrowers.
- There are two primary types: simple interest and compound interest.
- It frequently appears in applications like credit cards, mortgages, and savings accounts.
- It is influenced by macroeconomic policies, specifically the Federal Reserve’s Federal funds rate.
Understanding Interest
Interest compensates one party for incurring risk and giving up the opportunity to use their funds while charging another party for borrowing the funds. For example, money deposited in a savings account earns interest as the bank loans money to other clients. The interest amount payable is influenced by a borrower’s creditworthiness and the loan’s nature and term. Generally, higher risks or longer loans lead to higher interest charges. The APR of a loan includes the interest rate and additional fees.
A Journey Through the History of Interest Rates
Interest’s widespread acceptance started during the Renaissance, though the practice dates back to ancient civilizations where charging interest was often condemned as immoral. During the Renaissance, borrowing for business growth normalized interest. Economic theorists like Adam Smith and Carl Menger later presented theories supporting interest rates. Islamic banking in countries like Iran, Sudan, and Pakistan offers interest-free banking through profit and loss sharing. Modern interest applications span products like mortgages, credit cards, and personal loans.
Calculating Interest: Simple Formulas, Complex Impact
The simplest way to calculate interest is:
Interest = Interest Rate * Principal or Balance
Properly accounting for interest can be complex. The stated interest rate as an APR doesn’t usually include compounding effects; effective annual rates give the actual cost. Periodic calculations may necessitate converting an annual rate (for example, 0.25% monthly for 3% annual interest).
Comparison: Simple vs. Compound Interest
Simple Interest: Calculated solely on the principal.
Compound Interest: Calculated on both the principal and previously earned interest.
While compound interest can exponentially boost savings, it may exponentially increase debt, placing significant financial pressure on borrowers if the accrued interest is converted into the principal.
Real-world Examples Featuring Interest
Credit Cards: Typically have a high APR, with interest accruing on unpaid balances.
Mortgages: Feature long-term interest payments, often oriented around 30 years.
Auto Loans: Short-term with a fixed interest rate.
Student Loans: Interest was paused during COVID-19.
Savings Accounts: Offer monthly interest earnings, which compound.
Invoices: Some businesses charge interest on late payments.
The Rule of 72 offers quick doubling time estimates for investments: 72 divided by the interest rate gives the years to double an investment.
Pros and Cons for Borrowers
Pros
Provides necessary capital, especially in emergencies.
- Strengthens credit history.*
- Enables leveraging for higher returns.*
Cons
Generates recurring expenses.
- Obligates borrowers to payments prioritizing interest.*
- Can lead to overwhelming debt.*
- Often has contractual obligations.*
Pros and Cons for Lenders
Pros
Generates significant cash flow.
- Offers passive income and capital efficiency.*
Cons
Increased tax liability as interest revenue is taxable.
- Potentially less effective than direct investments.*
- Can attract negative attention in some cases.*
Interest’s Role in the Economy
Low-interest rates stimulate economic growth by making borrowing cheaper, benefiting consumers making large purchases. However, persistent high-interest rates signify a robust economy. Interest rates plunged due to COVID-19 but were later raised, increasing borrowing costs across the board.
What Is Accrued Interest?
Accrued interest is unpaid interest accumulated over a period. For a borrower, it’s interest due but not yet paid; for a lender, it’s earned interest not yet received. It is crucial in financial reporting.
The Best Way to Earn Interest
The best way to earn interest is by assessing the risk profiles of investments and selecting reliable borrowers. Defense against borrower defaults is important for safeguarding your principal amount.
How Much Interest Do Bank Accounts Pay?
Interest rates on bank accounts vary with economic conditions. Rates dipped near 0% during COVID-19 but climbed above 2% as the economy recovered.
The Bottom Line
Interest drives our economy, enabling money to circulate rather than sit idle. It incentivizes borrowing and lending, fostering economic activity and prosperity.
Related Terms: simple interest, compound interest, interest rate, loan, savings account.
References
- Islamic Finance Foundation. “The Establishment of National Interest Free Banking Systems in Iran, Sudan and Pakistan”.
- Federal Student Aid. “COVID-19 Loan Payment Pause and 0% Interest”.
- Board of Governors of the Federal Reserve. “Federal Reserve Actions to Support the Flow of Credit to Households and Businesses”.
- Board of Governors of the Federal Reserve System. “Federal Reserve Issues FOMC Statement”.
