When you let someone (like a bank) use your money, you extend credit and get paid interest. When you get a loan, you acquire debt and pay interest. Usually, the amount you receive or pay gets quoted at an annual rate, but it doesn't always have to be. Interest costs require additional repayments on the deposit or original loan balance. Because of interest, you will eventually repay more than you borrow from a lender. Lenders make money from your interest payments.

Understanding interest and its impact on your financial well-being are vital, regardless of whether you are financially secure or struggling. This blog is here to help you understand what interest means, how it works, and the various types of interest.

What is Interest?

There are different meanings of the word Interest. In financial terms, interest is the cost you pay when you borrow funds. On the other hand, interest can also be the reward for depositing funds or the money you gain for loaning out funds. You are essentially charging your bank or credit union to hold your money if your savings account receives interest. Most likely, the financial institution uses those funds to lend to borrowers by charging them interest on the loan.

The interest you pay as a borrower or receive as a lender is generally expressed as a percentage, known as the interest rate.

How Does Interest Work?

There are a variety of variables that banks and other financial institutions consider while setting interest rates. When you take out a loan, the interest you pay is usually calculated as a percentage of a loan principal. As mentioned in the loan agreement, a borrower usually pays interest payments monthly, semi-annually, or annually. Knowing the interest rate can help you estimate the total cost you will pay when your loan is repaid.

Every loan can have a different interest rate, affecting your debt. Understanding how to calculate interest to know how much you will ultimately owe before borrowing.

How Do I Calculate Interest?

The simplest method of calculating interest is multiplying the outstanding principal by the interest rate. If you have the necessary information, you can quickly compute loan interest if a lender uses the simple interest method. To determine the total interest cost, you'll need the principal loan amount, the interest rate, and the time you have to repay the loan.

Even though your monthly payments are fixed, the interest you'll pay each month can depend on the unpaid principal amount. So, if the lender doesn't impose prepayment penalties, paying off the loan before your loan term ends could result in significant interest savings.

You should note that there are different types of interest, which you'll read further in this article. The calculation of interest for a loan can vary with each interest type.

Interest Examples

For borrowers

Let's say you take out a vehicle or personal loan of $20,000 to purchase a car with an interest rate of 10% APR. You are now responsible for repaying the principal ($20,000) and the interest the lender charges ($2,000) if the loan term is for one year. Your total repayment would be $22,000.

For savers

On the other hand, if you have just received an unexpected windfall of $20,000 and want to earn interest. You could deposit it in a savings account and earn interest from the bank. Suppose you deposit your money in an account yielding a 2% Annual Percentage Rate compounded annually. At the end of the first year, you would have earned $400 and ended up with $20,400 in your savings account. The $400 is the amount of interest your money made for you.

How are Interest Rates Determined?

Overall, the supply and demand for money combine to affect interest rates charged when borrowing money. As the supply of credit increases, the cost of credit decreases. Some primary influences include the Federal Reserve, investor demand for U.S. Treasury notes and bonds, and the banking industry. The Federal Reserve, also known as the Fed, affects short-term lending rates by setting the Secured Overnight Financing Rate (SOFR), which affects the Prime Rate. The Prime Rate is a baseline for what banks charge to the most highly qualified customers to borrow. Long-term rates for money, such as 15yr or 30yr mortgages or car loans, are generally independent of the Fed rates being impacted more heavily by Treasury note yields. Retail or consumer lending interest rates often start at the prime rate. The individual risk factors are assessed and contribute to the final interest rate offered for the loan.

A retail lender may charge different interest rates depending on several criteria:

• Length of the loan
• Loan type or nature
• Borrower's creditworthiness or credit score

What is a Good Interest Rate?

A higher interest rate on borrowing money makes the loan more expensive as you're paying more to use that money. But a higher interest rate is advantageous when you are receiving interest payments. To determine if your interest rate is good, you must first consider whether you are borrowing or lending. If you are borrowing, research to compare rates offered for the type of loan you want and your credit score. A great starting point is to find out the prime interest rates for banks found at the Wall Street Journal prime rate. If you are saving money and want to find the best rates offered. Compare what local and national banks and credit unions are showing for rates. Again, the more research and informed you are, the better off you will be.

Now that you know, your interest rate depends on several factors. You can make an effort to improve your chances of getting the best interest rate possible based on your needs and situation.

Types of Interest

There are various types of interest, but simple and compound interest rates are the two significant types related to loans. It would be helpful if you understood other terminologies related to interest rates, including fixed, variable, and prime rates.

• Simple interest is computed using a rate of interest charged against the principal debt or outstanding amount at predetermined intervals. As a result, calculating simple interest is very simple, and the borrower can know the likely loan repayments or investment returns well in advance.
• Simple Interest = Principal x Interest Rate x Time.
  Example: the cost of $20,000 borrowed at a 10% interest rate over the course of a year will be $2,000 calculated using the simple interest methodology.
• Compound interest is the idea of charging interest on top of interest. It includes the interest calculated on a loan or deposit based on the initial principal and accumulated interest from previous periods. Compounding frequency can also be daily, quarterly, semi-annually, yearly, or any other predetermined recurrence rate.
• Compound Interest = Principal x (1 + annual interest rate as a percentage) raised to the number of compound periods -1
  The power of compound interest is that it accumulates at an ever-accelerating rate. As the amount grows over time, it grows faster.
• Fixed interest makes calculating and forecasting much simpler. A loan or credit line with a fixed interest rate has a non-fluctuating, fixed interest rate throughout the entire term of the loan or line of credit. A great benefit is that changes in market interest rates have no impact on the fixed interest rate.The principal loan amount is multiplied by the fixed interest rate to obtain the fixed interest that will be charged for each interval period of your monthly payment. A $10,000 loan with a fixed interest rate of 6.5% per year over five years will cost the borrower $650 in interest per year.
• Variable interest, also known as floating interest, is calculated by a rate that can fluctuate over time. The prime rate, which banks use to lend to borrowers with good credit, is typically tied to the variable rate. Borrowers can benefit or incur losses if this base rate decreases or increases.Banks frequently use variable interest rates to try to protect themselves against changes in the market. They can use them to regulate the effects of inflation and rising interest rates. Variable interest rates are frequently unfavorable for consumers because they are unpredictable.
• The prime rate is an interest rate determined by individual banks. Banks and other lenders often use it as a reference point when setting their interest rates for various products, such as loans, credit cards, or mortgages.

Conclusion

Understanding interest rates is essential whether you're a borrower searching for a better deal on a car loan or credit card or an investor looking for a higher rate of return on investment. Knowing the interest rate, how it's determined, and how it will affect your budget allows you to fully take charge of your finances.