What is Interest?

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DEFINITION:

Interest is the price of borrowed money – what you pay to use someone else’s money, or what you charge others to whom you lend money.

Understanding interest

When you borrow money, there are several reasons why the lender won’t give it to you for free. For one, the same amount of money today will probably be worth less in the future because prices are likely to rise due to inflation. The lender could earn a return on the money if he didn’t give it to you. And he takes the risk that you won’t pay the money back. To compensate for these disadvantages, lenders usually charge interest – the cost of borrowing money. You can earn interest by putting your money in savings accounts or certificates of deposit (CDs), or you can pay interest on a student loan, mortgage, or credit card. There are different ways to calculate interest, so be sure to read the fine print

EXAMPLE

Imagine that you borrow $200 for one year at an interest rate of 3%. This means that at the end of the term, you will have to pay back the original $200 borrowed (the principal) and $6 in interest. Let us say your friend applies for the same loan from the same institution, but receives an interest rate of 10%. At the end of a year, she would pay $200 plus $20 in interest. The same loan can have different interest rates depending on market rates and how risky the lender thinks the borrower is. These are small numbers, but for larger loans and a longer period of time, interest rates can make a big difference!

Takeaway

Just like in preschool, people don’t always like to share…

Especially if there are no guarantees that they will get their stuff back. Interest gives the lender the confidence they need to put their money up for grabs for a period of time and take on all the risks that come with it.

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