Interest is the expense of borrowing money from someone else. You pay interest when you borrow money. You get interest when you lend money.

You’ll learn more about interest in this section, including what it is and how to calculate how much you earn or owe based on whether you lend or borrow money.

**What is interest?**

Interest is computed as a percentage of a loan (or deposit) amount and is paid to the lender on a regular basis in exchange for the use of their funds. Although interest is commonly expressed as an annual rate, it can be calculated for periods longer or shorter than a year.

In addition to the original loan balance or deposit, interest is money that must be repaid. To put it another way, consider the following question: What does it take to get a loan? The solution is to spend more money.

**How Does Interest Work?**

There are various methods for calculating interest, and some are more advantageous to lenders than others. The decision to pay interest is based on what you get in return, and the decision to earn interest is based on the various investment options available.

**When taking out a loan**: To borrow money, you must be able to repay it. Furthermore, you must refund more than you borrowed to compensate the lender for the risk of loan to you (and their inability to utilize the money elsewhere while you use it).

**When it comes to lending:** If you have extra cash, you can lend it out personally or put it in a savings account, thereby allowing the bank to lend it out or invest it. You can expect to earn interest in exchange. If you aren’t going to make any money, you may be tempted to spend it instead, because there isn’t much use in waiting.

**How much interest do you pay or earn?**

It is dependent on:

- The rate of interest
- The total loan amount
- How long does it take to pay back the loan?

The borrower will pay more if the interest rate is higher or the loan is for a longer period of time.

Example: If you choose a simple interest, an interest rate of 5% per year with a balance of $100 results in interest payments of $5 per year. Use the Google Sheets spreadsheet with this example to view the calculation. To see how the interest cost changes, alter the three criteria indicated above.

Simple interest is not used by most banks or credit card companies. Instead, interest compounds, resulting in faster-growing interest amounts.

**How Do I Earn Interest?**

When you lend money or put money into an interest-bearing bank account like a savings account or a certificate of deposit, you earn interest (CD). Banks perform the lending for you: they take your money and use it to make loans to other customers and invest it, and they give you a piece of the profit in the form of interest.

The bank pays interest on your funds on a regular basis (every month or quarter, for example). You’ll notice a transaction for the interest payment, as well as an increase in your account balance. You have the option of spending the money or keeping it in the account to generate interest. When you leave the interest in your account, your savings can really take off; you’ll earn interest on both your original deposit and the money added to your account.

Compound interest is when you earn interest on top of the interest you already have.

For example, suppose you deposit $1,000 in a savings account with a 5% interest rate. Over the course of a year, simple interest would earn you $50. To figure out:

- Take $1,000 in savings and multiply it by 5% interest.
- In this case, $1,000 multiplied by.05 equals $50 in earnings (see how to convert percentages and decimals).
- After one year, the account balance is $1,050.

Most banks, on the other hand, compute your interest profits every day, not simply once a year. Because you take advantage of compounding, this works in your benefit. Assuming your bank compounds interest on a daily basis, here’s how it works:

- After a year, your account balance would be $1,051.16.
- The annual percentage yield (APY) on your investment would be 5.12%.
- Over the course of a year, you would earn $51.16 in interest.

The difference may appear insignificant, but we’re only talking about the first $1,000 here. You’ll earn a little more for every $1,000 you earn. The process will continue to snowball into bigger and bigger rewards as time passes and you deposit more. If you leave the account alone for another year, you’ll earn $53.78 instead of $51.16 the first year.

This example comes with a Google Sheets spreadsheet. To understand more about compound interest, make a copy of the spreadsheet and make adjustments.

**When Will I Be Required to Pay Interest?**

When you borrow money, you will almost always be required to pay interest. However, because there isn’t usually a line-item transaction or a separate bill for interest costs, this may not be clear.

**Debt that is paid in installments:** The interest charges of loans like a traditional home, auto, and student loans are built into your monthly payment. A component of your monthly payment goes toward paying down your debt, but another amount is used to cover your interest costs. You pay off your debt over a set length of time with these loans (a 15-year mortgage or five-year auto loan, for example).

**Debt that is revolving:** Other loans are revolving, which means you can borrow additional money month after month and pay it back in installments. 1 Credit card, for example, allow you to spend as much as you like as long as you keep it under your credit limit. Interest computations differ, but figuring out how interest is calculated and how your payments operate isn’t difficult.

**Additional expenses include**: An annual percentage rate (APR) is frequently used when quoting loans (APR). This figure indicates how much you pay each year and may include additional expenditures in addition to interest. The interest rate is your pure interest cost (not the APR). Closing charges or finance costs, which are technically not interest costs, are deducted from the amount of your loan and your interest rate on some loans. It would be beneficial to understand the difference between an interest rate and an annual percentage rate (APR). An APR is usually a superior tool for comparing purposes.

**Points to Remember**

- Interest is the money you either owe or get from borrowing or lending money.
- Interest is computed as a proportion of the loan (or deposit) that you have taken out.
- When you lend money or put money into an interest-bearing bank account, you earn interest.
- Compound interest is when you earn interest on top of the interest you already have.