What is interest? Definition and examples
Interest is the money you pay on top of the amount you borrow which compensates lenders for making their money available as well as the risk they take.
For the borrower, it is like a rental cost, while for the lender it is an income for lending – for risking their money and doing without it for a given period.
If this system did not exist, or was not allowed, there would be virtually no lending of money outside arrangements between family members or close friends. If there were no lending there would be considerably less economic activity.
Interest can be described as the cost of using somebody else’s money over a specific period. When people borrow money, they pay a fee for that privilege. When they lend money, they are compensated.
How much the borrower has to pay is calculated as a percentage of the loan balance and is paid to the lender periodically. The payments are made for the privilege of using the lender’s money.
According to ft.com/lexicon, interest by definition is:
“What it costs to borrow money and what is earned from lending it or putting it on deposit. It is normally expressed in annual terms and as a percentage of the amount borrowed, lent or deposited. The term also means a share of ownership.”
Banks pay savers interest
People who save money and deposit in a savings account earn interest. They are, effectively, lending the bank money. Even though savers do not see themselves as lenders – they still see banks as lenders – they are, and their banks are borrowers.
Banks offer a wide range of accounts, which can be broadly divided into five types:
- savings accounts
- certificates of deposit
- money market deposit accounts
- interest-bearing checking accounts
- basic checking accounts.
They all pay interest, apart from the basic checking account.
If you have an overdraft arrangement and your account is in debit, you will have to pay extra for that privilege.
How much the borrower has to pay depends on the interest rate charged on the loan. This is quoted as a percentage rate per year.
A lower rate means the borrower pays less, while a higher rate means he or she pays more.
For example, if you borrow $100 for one year at a rate of 10%, you will have to return the $100 you borrowed plus $10, assuming you use simple interest.
Interest versus profit
It does not mean the same as profit. Interest is paid to the lender, while profit is received by the owner of an asset, enterprise or investment.
Interest may form part or the whole of the profit of an investment, but the two concepts are completely different.
For the lender interest is income, in the same way as fares paid by customers are to taxi drivers, or the money shoppers pay at the checkout is income for the supermarket.
For a bank, interest is part of revenue, while profit is what is left over after paying off all costs.
What is compound interest?
This is added onto prior interest as well as the principal (original amount lent). Compounding makes the total amount of debt grow exponentially.
Imagine you borrow $100 dollars at 10% annual interest, and you pay it all back in one go at the end of two years. The interest on the loan will be $10 at the end of the first year, plus $11 at the end of the second year, i.e. a total of $21 will be added to the original $100.
You are charged $11 at the end of the second year because the amount you owe at the end of the first year is $100 + $10 = $110. So, in order to calculate how much is owed at the end of the second year, you have to calculate 10% of 110, which is 11.
In practice, interest is generally calculated on a daily, monthly, or annual basis, and its impact is greatly influenced by its compounding rate.
Compounding also applies to savers. For savers it is the reinvesting of interest, rather than paying it out, so that interest in the next period is earned on the principal sum deposited plus what had been accumulated previously.
This Wall Street Survivor video explains what interest rates are and how they can have a profound effect on people’s stock portfolio and their ability to buy a house. Their effect is so important that the Chairman of the Federal Reserve – America’s central bank – is probably the second most powerful person in the United States after the President.