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INVESTING INVESTING BASICS

Interest: Definition and Types of Fees For

Borrowing Money
By JAMES CHEN Updated September 13, 2022

Reviewed by CHIP STAPLETON

Fact checked by HANS DANIEL JASPERSON

What Is Interest?
Interest is the monetary charge for the privilege of borrowing money. Interest
expense or revenue is often expressed as a dollar amount, while the interest
rate used to calculate interest is 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).
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Interest may be earned by lenders for the use of their funds or paid by
borrowers for the use of those funds.
Interest is often considered simple interest (based on the principal
amount) or compound interest (based on principal and previously-
earned interest).
Interest is often associated with credit cards, mortgages, car loans,
private loans, savings accounts, or penalty assessments.
Interest is highly dependent on macroeconomic policy dictated by the
Federal Reserve's Federal funds rate.

Interest
Understanding Interest
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Interest is the concept of compensating one party for incurring risk and
sacrificing the opportunity to use funds while penalizing another party for the
use of someone else's funds. The person temporarily parting ways with their
money is entitled to compensation, and the person temporarily using those
funds is often required to pay this compensation.

When you leave money in your savings account, your account is credited
interest. This is because the bank uses your money and loans it out to other
clients, resulting in you earning interest revenue.

The amount of interest a person must pay is often tied to their

creditworthiness, the length of the loan, or the nature of the loan. All else being
equal, interest and interest rates are higher when there is greater risk; as the
lender faces a greater risk in the borrower not being able to make their
payments, the lender may charge more interest to incentivize them to make the
loan.

FAST FACT
APR includes the loan's interest rate, as well as other charges, such
as origination fees, closing costs, or discount points.

History of Interest Rates

This cost of borrowing money is considered commonplace today. However, the
wide acceptability of interest became common only during the Renaissance.
Interest is an ancient practice; however, social norms from ancient Middle
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Eastern civilizations, to Medieval times regarded charging interest on loans as a
kind of sin. This was due, in part because loans were made to people in need,
and there was no product other than money being made in the act of loaning
assets with interest.

The moral dubiousness of charging interest on loans fell away during the
Renaissance. People began borrowing money to grow businesses in an attempt
to improve their own station. Growing markets and relative economic mobility
made loans more common and made charging interest more acceptable. It was
during this time that money began to be considered a commodity, and the
opportunity cost of lending it was seen as worth charging for.

Political philosophers in the 1700s and 1800s elucidated the economic theory
behind charging interest rates for lent money, authors included Adam Smith,
Frédéric Bastiat, and Carl Menger.

Iran, Sudan, and Pakistan use interest-free banking systems. Iran is completely
interest-free, while Sudan and Pakistan have partial measures. [1] With this,
lenders partner in profit and loss sharing instead of charging interest on the
money they lend. This trend in Islamic banking—refusing to take interest on
loans—became more common toward the end of the 20th century, regardless of
profit margins.

Today, interest rates can be applied to various financial products including

mortgages, credit cards, car loans, and personal loans. Interest rates started to
fall in 2019 and were brought to near zero in 2020.
Formula and Calculation for Interest
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In its most basic form, interest is calculated by multiplying the outstanding
principal by the interest rate.

Interest = Interest Rate * Principal or Balance

The more complex aspect in calculating interest is often determining the

correct interest rate. The interest rate is often expressed as a percentage and is
usually designated as the APR. However, the APR often does not reflect any
effects of compounding. Instead, the effective annual rate is used to express the
actual rate of interest to be paid.

Often, an annual rate must be converted to calculate the applicable interest

earned in a given period. For example, if a savings account is to pay 3% interest
on the average balance, the account may award 0.25% (3% / 12 months) each
month.

The applicable interest rate is then multiplied against the outstanding amount
of money related to the interest assessment. For loans, this is the outstanding
principal balance. For savings, this is often the average balance of savings for a
given period.

In either case, the amount of interest assessed each period will likely change.
For loans, borrowers will have likely made payments that reduce the principal
balance, resulting in lower interest. For savers, general activity (including the
addition of last month's interest) often changes the applicable balance.
 Important: Your credit score has the most impact on the interest rate
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you are offered when it comes to various loans and lines of credit.

Simple Interest vs. Compound Interest

Two main types of interest can be applied to loans—simple and compound.
Simple interest is a set rate on the principal originally lent to the borrower that
the borrower has to pay for the ability to use the money. Compound interest is
interest on both the principal and the compounding interest paid on that loan.
The latter of the two types of interest is the most common.

For obvious reasons, individuals attempting to earn interest prefer compound

interest agreements. This agreement results in interest being earned on interest
and results in more total earnings. Savings accounts with banks often earn
compound interest; any prior interest earned on your savings is deposited into
your account, and this new balance is what earns interest in future periods.

On the other hand, compound interest is extremely concerning for borrowers

especially if their accrued compound interest is capitalized into their
outstanding principal. This means the borrower's monthly payment will
actually increase due to now having a greater loan than what they started with.

Common Applications of Interest

There's countless ways a person can charge or be charged interest. Below are
some common examples of where interest may be earned by one party and
paid by another.
Credit cards: Among the methods of borrowing money that incurs the
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highest amount of interest, credit cards are known for having a high APR.
Consumers may make minimum monthly installment payments; in return,
interest expense may accumulate and is earned by the credit card
providers/underlying financial institutions.
Mortgages: Among the longest-term loans, mortgages often incur interest
over the entirety of their potential 30-year term. Though interest may be
assessed as a fixed or variable rate, it is theoretically reduced over time as
the borrower pays down the original loan principal amount.
Auto loans: An example of a shorter-term loan, auto loans are often awarded
for terms up to six years. Interest is often charged as a fixed rate, and the
dealership extending credit may have an in-house financing department
that collects the interest revenue.
Student loans: During COVID-19, student loan payments were paused, and
prevailing loan rates were dropped to 0%. [2] This meant that for a while, all
loans incurred no interest assessments.
Savings accounts: Often a positive type of interest for most consumers,
savings accounts earn monthly interest assessments. Also called dividends,
consumers have these deposits are automatically credited to your account.
Invoices: Though many companies may assess a late fee, some companies
choose to assess an interest charge on outstanding and late invoices. The
idea is since the late payer is technically borrowing money from the invoice
holder, the invoice holder is due interest.

Tip: A quick way to get a rough understanding of how long it will take
for an interest-bearing account to double is to use the so-called rule
 of 72. Simply divide the number 72 by the applicable interest rate. At
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4% interest, for instance, and you’ll double your investment in
around 18 years (i.e., 72/4).

Advantages and Disadvantages of Paying Interest

Imagine a situation where you absolutely need reliable transportation to get to
work. There is no public transit system, you do not own a car, work is far away,
and you can't afford to buy an entire car outright. The largest advantage of
paying interest is it is a relatively low expense compared to alternatives.

Paying interest also means a payer is holding debt, building their credit history,
and potentially effectively using leverage. For example, real estate developers
often borrow money to construct and rent buildings. If the rate of return on the
building is greater than the interest rate they are charged, the company is
successfully using someone else's money to make money for themselves.

On the downside, interest is a recurring cash expense. Payers are often

contractually obligated to pay interest, and monthly payments are typically
applied to interest assessments before paying down the principal. Consumers
may find interest assessments overwhelming. In addition, having too many
loans and too high of monthly payments may restrict a borrower from being
able to take out more credit.

Interest for Borrowers

Pros
• May be the result of much-needed capital; relatively-speaking, it may be
worth the small expense during emergencies.
 • Is a result of building a strong credit history
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• May be used to leverage returns and generate higher profits

Cons
• Is a real, often monthly expense requiring cash outlay
• Is usually paid before any principal balance can be paid down
• May compound and become overwhelming for a borrower to overcome
• Are contractually obligated to be paid

Advantages and Disadvantages of Collecting Interest

A strategy for many investors is to collect interest. Often a fixed amount (or at
least consistent), interest often provides positive cash flow that is a reliable
source of income depending on the creditworthiness of the person borrowing
the money. Instead of having capital sitting around and not being used, lending
money to others is a more efficient way of deploying capital, especially in the
short term when the lender may need that money for a specific reason in the
longer term.

Interest is also touted as one of the simplest forms of passive income. Loans
may require little to no administration or maintenance after the agreement is
signed. Lenders may simply collect interest and principal payments.

There are some downsides to collecting interest. First, interest revenue is

taxable; even a small amount may push a taxpayer into a higher tax bracket.
Next, because you are collecting interest, this means you are allowing someone
else to use your capital. Though you may be satisfied collecting interest, there
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will often be greater earning potential had you utilized the capital yourself.

Also, collecting interest may have philosophical opponents. Consider student

loan debt assessments. While some say interest rates near 10% are reasonable
for the amount of risk these lenders are incurring, others claim these rates are
predatory to young adults and should not be assessed.

Interest for Lenders

Pros
• May provide source of cash flow if interest payments are collected
monthly/frequently
• May be a passive source of income
• May provide a consistent stream of income if the borrower is reliable in
their payments
• Is a more efficient use of capital instead of not loaning it out

Cons
• Will increase a taxpayers tax liability
• May be lower than what could have been earned had the lender deployed
capital for their own investment purpose
• May attract negative attention in some situations depending on the
borrower, rate of interest, and circumstance

Interest and Macroeconomics

A low-interest-rate environment is intended to stimulate economic growth so
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that it is cheaper to borrow money. This is beneficial for those who are
shopping for new homes, simply because it lowers their monthly payment and
means cheaper costs. When the Federal Reserve lowers rates, it means more
money in consumers' pockets, to spend in other areas, and more large
purchases of items, such as houses. Banks also benefit from this environment
because they can lend more money.

However, low-interest rates aren't always ideal. A high-interest rate typically

tells us that the economy is strong and doing well. In a low-interest-rate
environment, there are lower returns on investments and in savings accounts,
and of course, an increase in debt which could mean more of a chance of
default when rates go back up.

In response to COVID-19, the Federal Reserve began enacting monetary policy

as early as March 2020. [3] Then, as the pandemic eased, the Federal Reserve
began raising the Federal funds rate. [4] As this Federal funds rate influences the
interest rate on many other types of loans, borrowers soon found it to be more
expensive to incur debt.

What Is Accrued Interest?

Accrued interest is interest that has been incurred but not paid. For a borrower,
this is interest that is due for payment, but cash has not been remit to the
lender. For a lender, this is interest that has been earned that they have not yet
been paid for. Interest is often accrued as part of a company's financial
statements.
What Is the Best Way to Earn Interest?
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There are now many ways investors can deposit funds into alternative
investments that generate interest. This also means investors must take care in
selecting borrowers. The best way to earn interest is to property research the
risk profile of your borrower; should they default on the loan, you may not have
recourse to recover your lost principal.

How Much Interest Do Bank Accounts Pay?

The amount of interest paid by bank accounts will widely vary based on
prevailing government rates and macroeconomic conditions. For example,
during the COVID-19 pandemic, while the Federal funds rate was low, interest
rates on bank accounts was near 0%. Then, as the pandemic eased, bank
accounts began paying interest greater than 2% on bank deposits.

The Bottom Line

Interest is a critical part of our high-functioning society. By allowing individuals
to borrower and lend money, society has greater economic prosperity by
encouraging spending. As a result, capital likely does not sit around idly; it is
borrowed by some and lent by others. Through the payment of interest,
individuals are encouraged to always be putting money to use.

ARTICLE SOURCES

Related Terms
Simple Interest Definition: Who Benefits, With Formula and
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Example
Simple interest is a quick method of calculating the interest charge on a loan. more

Personal Loan Interest Rates: How a Personal Loan Is

Calculated
Learn how personal loan interest rates work, how rate types differ, and what the average
interest rate is on a typical personal loan. more

Annual Percentage Rate (APR): What It Means and How It

Works
Annual Percentage Rate (APR) is the interest charged for borrowing that represents the
actual yearly cost of the loan expressed as a percentage. more

The Rule of 72: Definition, Usefulness, and How to Use It

The Rule of 72 is a shortcut or rule of thumb used to estimate the number of years
required to double your money at a given annual rate of return and vice versa. more

Zero-Coupon Mortgage
A zero-coupon mortgage is a long-term commercial mortgage that defers all payments of
principal and interest until maturity. more

Tax-Deductible Interest: Definition and Types That Qualify

Tax-deductible interest is a borrowing expense that taxpayers can claim on federal and
state tax returns to reduce their taxable income and save money. more
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