What Is Interest? Definition, How It Works, Examples

What Is Interest?

Interest is the monetary charge for the privilege of borrowing money, typically expressed as an annual percentage rate (APR). Interest is the amount of money a lender or financial institution receives for lending out money. Interest can also refer to the amount of ownership a stockholder has in a company, usually expressed as a percentage.

Key Takeaways Interest is the monetary charge for borrowing money—generally expressed as a percentage, such as an annual percentage rate (APR).Key factors affecting interest rates include inflation rate, length of time the money is borrowed, liquidity, and risk of default.Interest can also express ownership in a company.

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What is an APR?

An Annual Performance Rate, or APR, is another rate you may encounter when taking out a personal loan, mortgage loan, auto loan or credit card. This rate is the amount of interest you will pay over the course of a year, including any extra fees your loan process may incur.

The APR will typically be .1 to .5% higher than the interest rate. If the APR is higher, expect to have more fees.

Many borrowers compare APRs when deciding between different loan options. These rates are valuable negotiating tools – it is not uncommon to reference the rate of a competing lender in order to secure the best rate available.

Do I Have to Pay Interest?

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

Installment debt

With loans like standard home, auto, and student loans, the interest costs are baked into your monthly payment. Each month, a portion of your payment goes toward 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 five-year auto loan, for example).

Revolving debt

Other loans are revolving loans, meaning you can borrow more month after month and make periodic payments on the debt. For example, credit cards allow you to spend repeatedly as long as you stay below your credit limit.

Interest calculations vary. Refer to your loan agreement 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. 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.

Does the rate of interest always stay the same?

Oh, that’s really good. But, is it always 10%?

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No, it changes a little bit every day based on the economy and other factors.

Okay. Well, thank you very much for telling me what an interest rate is.

You’re welcome.

Remember, finance is your friend!

How interest works when lending

Typically, banks use a number of different factors to determine your interest rate, including your credit score and debt-to-income ratio. It also depends on the type of lending, such as a credit card or a home loan. On top of this, commercial lenders usually also charge a separate fee for establishing a loan with a customer.

Let’s say you want to apply for a $5,000 loan from your bank. To establish the interest rate it will charge you, your bank must consider what it pays in interest to get the funds it will lend to you (say, 4 percent). The bank will also have loan servicing costs and overhead it will allocate to your interest rate (say, 2 percent). And of course the bank wants to account for default risk and make some profit (say, another 2 percent). To account for these costs, your loan may carry an interest rate around 8 percent.

What is Bank Rate?

‘Bank Rate’ is the single most important interest rate in the UK. It is our job to set this interest rate. We explain why we decide to keep the rate the same or change it in our Monetary Policy Report.

In the news, it’s sometimes called the ‘Bank of England Base Rate’ or even just ‘the interest rate’.

Bank Rate influences lots of other interest rates in the economy. That includes the lending and savings rates offered by high street banks and building societies.

For example, in 2020 we cut Bank Rate to 0.1% at the start of the Covid-19 (coronavirus) crisis. This reduced the rates at which high street banks could borrow money from us, which in turn meant they could lend to their customers at lower rates. 

Banks lowered the interest rates on some loans, such as mortgages, but also offered lower interest rates on some savings accounts.

Since then we’ve put Bank Rate up to 0.75%. We expect that increase to be reflected in some mortgages and savings. 

What is interest anyway?

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Well, you can think of interest like rent on your money, just like you pay rent for an apartment.

The people who rent it to you are letting you use the apartment for money (rent), and you let the bank use your money for extra money, which is called interest.

Oh!

How to Calculate Interest

The amount of interest that accrues (accumulates) on loans from month to month is determined by a simple daily interest formula. This formula consists of multiplying the loan balance by the number of days since the last payment, times the interest rate factor.

Interest Rates

It’s important to keep finances healthy for many reasons. Bad credit can have a negative effect on interest rates charged on loans and/or credit cards. For example, if a lender checks a potential borrower’s credit report and finds the borrower has a record of missing payments, that lender may decide to deny credit for the customer or charge a higher interest rate for the loan than they would for a customer who has a clean credit report. A credit history in good shape can save money by allowing borrowing at lower interest rates.

How Does it All Work?

The amount of interest that will be paid depends on:

  • The amount of money borrowed (i.e., the principal).
  • The rate at which interest is charged (i.e., the interest rate).
  • Whether the government pays the interest during periods of in-school enrollment or deferment.
  • The length of time taken to repay the loan.

Pros and Cons of Interest

While paying interest isn’t always ideal, there can be some benefits to using credit. That said, there can be some significant drawbacks, especially with high-interest credit products.

Pros

  • It allows you to finance large purchases. In an ideal world, no one would need credit to buy a home, a car or other large purchases. But that’s not an option for most people. So while paying interest may not be super appealing, it makes it possible for people to obtain housing, transportation and other important things.
  • You can leverage your money. If your credit is in great shape and you can qualify for low-interest loans, you can use that opportunity to leverage your money. For example, let’s say you can get a 2.5% interest rate on an auto loan to buy a $20,000 car, or you can pay for it outright with cash. With such a low interest rate, it may make more sense to put some money down and use the rest of your cash to invest and earn more in returns than what you would’ve saved by buying the car in cash.

Cons

  • Some credit products are expensive. If your credit score is low, you may have a hard time qualifying for low interest rates. The higher the rate, the more pressure your monthly payment will put on your budget. Even if you have great credit, interest rates can vary depending on the product you choose. For example, the average 30-year fixed mortgage interest rate as of September 16, 2021, was 2.86%, according to Freddie Mac. With personal loans and credit cards, average rates were 9.58% and 16.30%, respectively, according to Federal Reserve data from May 2021.
  • Interest can cause your balance to increase. Making low monthly payments on an account that has a high balance and high interest could cause your loan balance to actually increase over time instead of decrease. This can happen when you’re on an income-driven repayment plan for federal student loans, for example.

Types of Interest Rates

There are a variety of interest rates, which include rates for auto loans and credit cards. As of November 2020, the average auto rate for a five-year loan for a new car was 4.22%. Meanwhile, for 30-year mortgages, the average fixed rate was 3.22%.

The average credit card interest rates vary according to many factors such as the type of credit card (travel rewards, cashback or business, etc.) as well as credit score. On average, the interest rate for credit cards as of November 2020 was 16.03%.

Your credit score has the most impact on the interest rate you are offered when it comes to various loans and lines of credit.

The subprime market of credit cards, which is designed for those with poor credit, typically carries interest rates as high as 25%. Credit cards in this area also carry more fees along with the higher interest rates and are used to build or repair bad or no credit.

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