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What is Interest?

How Interest Works with Everyday Loans

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Interest is the cost of using somebody else’s money. When you borrow money, you pay interest. When you lend money, you earn interest. Learn more about what interest is and how it works.

What is Interest?

A question may help you get a handle on how interest works: what does it take to borrow money? The answer: more money. You can borrow money for a home, a business, or almost anything else. In return, you’ll have to pay that money back along with a little extra. The extra money is interest.

Interest is the price you pay (or a fee if you prefer) to use somebody else’s money. How much will it cost you? It depends in part on your interest rate. Higher rates mean you pay more for the same amount of money.

Earning Interest

When you lend money, you often earn interest. For example, depositing money into a bank account is like lending money to the bank. They’ll use your cash to make loans (charging borrowers more interest than they pay you). The bank pays you interest when you use savings accounts and certificates of deposit (CDs) because they want you to keep your money at the bank. Unless you have something better to do with the funds, you’ll leave it in the bank to earn interest. Periodically (every month or quarter, for example) the bank pays interest. You’ll see your account balance go up, and you can either spend the money or keep it in the account so it continues to earn interest. Your savings can build momentum when this happens -- you earn interest on money that already earned interest. This process is called compounding.

Paying Interest

When you borrow money, you generally have to pay interest. You may not notice that you’re paying interest, especially with loans like home loans and auto loans. The interest you pay is baked into your monthly payment calculation. With every monthly payment you repay a portion of your original loan and a portion of your interest costs.

See how the process works by learning about loan amortization.

Calculating Interest

How much interest are we talking about? It depends on a few factors:

As these inputs increase, so does the amount of interest. To understand what interest does to your particular situation, run some numbers. Play with a few calculators and figure out how to optimize your saving and borrowing.
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