Everything You Need to Know About Interest

Everything you need to know about interest
Photo Credit: TheStreet

Interest, as a financial concept, affects almost everyone. Many people tend to shy away from learning about financial concepts, like interest because they seem complex, but this isn’t always true.

Knowing what interest is and how it works is invaluable, as it will help you manage your money more effectively.

What is Interest?

Interest is the price of borrowing or lending money. If you need to borrow money, you’ll be charged interest on the amount you borrow.

When you save or invest money in a bank, the bank uses your capital for other transactions, so you earn interest on the money you deposit in a bank account.

How Does Interest Work?

The interest you pay or earn is worked out as a percentage of the amount of money you borrow or lend.

Anytime you take a loan, you’ll have to pay interest. This means you’ll have to repay the amount you borrowed, known as the principal amount, and the cost of borrowing the money.

Interest rates vary, depending on several factors, including the loan type.

On the contrary, when you open a savings or investment account and deposit money into it, you’ll be paid interest on the amount in your account, which will be calculated based on the interest rate.

Factors That Affect Interest Rates

Interest rates are dynamic, meaning that they constantly fluctuate. Whether you borrow or invest money, there are several factors that cause the interest rate to change. Some of these factors include:

#1. The Supply and Demand for Money

Like other commodities, when there’s a demand for money or credit, the price of it goes up. So, when there are a demand for money, the interest rate increases. This is typically the case in growing economies.

Businesses and manufacturing companies borrow money to fund their growth in the long and short term. As people secure jobs, they may need to borrow money to buy homes, cars, and other expenses, pushing the interest rate.

When people fail to repay their loans within the stipulated timeframe, the amount of money available for banks and financial institutions to lend to others reduces. This will also increase the interest rate.

On the flip side, when there’s a decrease in demand for credit, that is, when fewer people and companies are taking out loans, the interest rate drops.

#2. The Government

Government spending and borrowing affect the interest rate. Also, the government controls the interest rate through its monetary policy.

When a country is in a financial deficit, meaning that government spending is higher than revenue, the interest rates will increase.

#3. Inflation

The cost of all goods and services is calculated by taking inflation into account. Since interest is the price of borrowing or lending money, inflation also affects it. When inflation increases, so do the interest rate.

#4. Loan Type

Each type of loan carries a different interest rate. Common loan types include mortgages, personal, car, and student loans. To determine the interest rate of each loan time, lenders or borrowers look at the risk, time frame, and tax considerations.

The risk is about the likelihood of the loan being repaid. If it’s considered high-risk, meaning there’s a good chance the borrower won’t repay the loan, the interest rate is higher. However, if a borrower is required to provide collateral, the interest rate will be lower since there is less risk.

The timeframe a borrower has to repay the loan is also considered. If the timescale is very long, the loan may not be repaid for reasons beyond the borrower’s control, for example. Also, with inflation, the value of the loan will be affected, which must also be considered.

#5. Personal Factors

Personal factors also contribute to how much interest a person is charged on loans they apply for. Individuals with a good credit score can get loans with lower interest rates and better terms than those with poor credit scores.

Interest rates vary by state, so the amount you pay will vary according to where you live.

Simple Vs. Compound Interest

Knowing how much interest you’ll be charged on a loan or how much you’ll earn on an investment is helpful. Because of this, it’s essential that you understand the way interest is calculated and have a good idea of the simple interest and compound interest difference.

Simple Interest

Simple interest is calculated on the principal amount you borrow or deposit and is usually a fixed rate. To calculate simple interest on a loan, use the following formula:

Loan amount x interest rate x number of years.

For example, if you borrow $1000 at an interest rate of 6% and have five years to pay it off, you will calculate your repayments and loan amount as follows:

1000 x 0.06 x 5 = 1300

The amount you borrow is $1000

The interest per year is $60

The interest over five years is $300

The total amount of the loan is $1300

Compound Interest

Compound interest accrues, meaning that it’s calculated based on the principal amount and the added interest. For this reason, investing early allows you to earn more money in the long run since you’ll earn money on the principal amount and the amount you earned in interest.

For example, if you invest $1000 at an interest rate of 6% over five years, it will be calculated as the following:

Interest in Year one: $1000 x 0.06=$ 60

Year two: $1000 + $60 = $1060

I$1060 x 0.06 = $63.6

Year three $1060 + 63.6 = $1123.6

$1123.6 x 0.06 = 67.40

Year four $1123.6 + 67.40 = $1191

$1191 x 0.06 = $71.46

Year five $1191 +$71.46 = $1262.46

$1262.46 x 0.06 = $75.47

TOTAL $1262.46 + 75.47 = $1337.93

Conclusion

Interest is the cost of debt of the price you pay for borrowing or lending money. Several factors affect the interest rate, including the supply and demand of money, government spending, inflation, and personal factors like where you live and your credit score.

Investing early is a good idea, as this allows you to benefit from compound interest, which is worked out on the principal amount and added interest.

References:

  1. Smartasset: Everything You Need to Know About Interest
  2. https://www.thebalance.com/what-is-interest-315436
  3. Thestreet: What are the Different Types of Interest and Why do They Matter?
  4. Bankrate: What is Interest?
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