Interest is the cost of using somebody else?s money. When
you borrow money, you pay interest. When you lend money, you earn interest.

There are several different ways to calculate interest, and
some methods are more beneficial for lenders. The decision to pay interest
depends on what you get in return, and the decision to earn interest depends on
the alternative options available for investing your money.

What Is Interest?

Interest is calculated as a percentage of a loan (or
deposit) balance, paid to the lender periodically for the privilege of using
their money. The amount is usually quoted as an annual rate, but interest can
be calculated for periods that are longer or shorter than one year.1?

Interest is additional money that must be repaid ? in
addition to the original loan balance or deposit. To put it another way,
consider the question: What does it take to borrow money? The answer: More
money.

When borrowing: To borrow money, you?ll need to repay what
you borrow. In addition, to compensate the lender for the risk of lending to
you (and their inability to use the money anywhere else while you use it), you
need to repay more than you borrowed.

When lending: If you have extra money available, you can
lend it out yourself or deposit the funds in a savings account (effectively
letting the bank lend it out or invest the funds). In exchange, you?ll expect
to earn interest. If you are not going to earn anything, you might be tempted
to spend the money instead, because there?s little benefit to waiting (other
than saving for future expenses).

How much do you pay or earn in interest? It depends on:

The interest rate

The amount of the loan

How long it takes to repay2?

A higher rate or a longer-term loan results in the borrower
paying more.

Example: An interest rate of five percent per year and a
balance of $100 results in interest charges of $5 per year assuming you use
simple interest. To see the calculation, use the Google Sheets spreadsheet with
this example. Change the three factors listed above to see how the interest
cost changes.

Most banks and credit card issuers do not use simple interest.
Instead, interest compounds, resulting in interest amounts that grow more
quickly (see below).3?

Earning Interest

You earn interest when you lend money or deposit funds into
an interest-bearing bank account such as a savings account or a certificate of
deposit (CD). Banks do the lending for you: They use your money to offer loans
to other customers and make other investments, and they pass a portion of that
revenue to you in the form of interest.4?

Periodically, (every month or quarter, for example) the bank
pays interest on your savings. You?ll see a transaction for the interest
payment, and you?ll notice that your account balance increases. You can either
spend that money or keep it in the account so it continues to earn interest.
Your savings can really build momentum when you leave the interest in your
account ? you?ll earn interest on your original deposit as well as the interest
added to your account.

Earning interest on top of the interest you earned
previously is known as compound interest.

Example: You deposit $1,000 in a savings account that pays a
five percent interest rate. With simple interest, you?d earn $50 over one year.
To calculate:

Multiply $1,000 in savings by five percent interest.

$1,000 x .05 = $50 in earnings (see how to convert
percentages and decimals).

Account balance after one year = $1,050.

However, most banks calculate your interest earnings every
day ? not just after one year. This works out in your favor because you take
advantage of compounding. Assuming your bank compounds interest daily:

Your account balance would be $1,051.16 after one year.

Your annual percentage yield (APY) would be 5.12 percent.

You would earn $51.16 in interest over the year.

The difference might seem small, but we?re only talking
about your first $1,000 (which is an impressive start, but it will take even
more savings to reach most financial goals).

With every $1,000, you?ll earn a bit more. As time passes,
and as you deposit more, the process will continue to snowball into bigger and
bigger earnings. If you leave the account alone, you?ll earn $53.78 in the
following year (compared to $51.16 the first year).

See a Google Sheets spreadsheet with this example. Make a
copy of the spreadsheet and make changes to learn more about compound interest.

Paying Interest

When you borrow money, you generally have to pay interest.
But that might not be obvious ? there?s not always a line-item transaction or
separate bill for interest costs.

Installment debt: With loans like standard home,1? auto,5?
and student loans,6? the interest costs are baked into your monthly payment.
Each month, a portion of your payment goes towards reducing your debt, but
another portion is your interest cost. With those loans, you pay down your debt
over a specific time period (a 15-year mortgage or 5-year auto loan, for
example). To understand how these loans work, read about loan amortization.

Revolving debt: Other loans are revolving loans, meaning you
can borrow more month after month and make periodic payments on the debt.7? For
example, credit cards allow you to spend repeatedly as long as you stay below
your credit limit. Interest calculations vary, but it?s not too hard to figure
out how interest is charged and how your payments work.

Additional costs: Loans are often quoted with an annual
percentage rate (APR). This number tells you how much you pay per year and may
include additional costs above and beyond the interest charges. Your pure
interest cost is the interest ?rate? (not the APR). With some loans, you pay
closing costs or finance costs, which are technically not interest costs that
come from the amount of your loan and your interest rate.8? It would be useful
to find out the difference between an interest rate and an APR. For comparison
purposes, an APR is usually a better tool.

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