Interest

What is interest?

Interest is the charge for borrowing money or the compensation a lender receives for lending funds. It’s normally expressed as a percentage of the principal and described as an annual percentage rate (APR). Interest can also describe ownership stake in a company (a percentage interest).

Key takeaways

• Interest compensates lenders for risk and the opportunity cost of lending; borrowers pay it for using someone else’s funds.
• Rates are typically quoted as APR but the effective annual rate includes compounding.
• Interest can be simple (on principal only) or compound (on principal plus previously earned interest).
• Common contexts include credit cards, mortgages, auto loans, student loans, savings accounts, and late invoices.
• Macroeconomic policy—especially central bank rates—strongly influences interest rates.

How interest works

Lenders charge interest to be compensated for credit risk and for giving up the ability to use their money. Borrowers’ rates reflect creditworthiness, loan term, loan type, and prevailing market rates. Banks pay interest on deposits because they lend that money to others; depositors earn interest as a return.

Important: your credit score is a primary factor lenders use to set the interest rate you’re offered.

Brief history

Charging interest has long economic roots but was once widely considered usury and morally objectionable in many societies. Acceptance grew during the Renaissance as lending became tied to commerce and investment. Today, interest is a core part of modern finance; some systems (notably Islamic finance) avoid conventional interest (riba) and use profit-and-loss sharing alternatives.

Formula and calculation

Basic formula:
Interest = Interest rate × Principal (for the period)

Notes:
* APR often excludes compounding effects; the effective annual rate reflects compounding.
* To compute interest for periods shorter than a year, divide the annual rate by the number of periods (e.g., monthly: annual rate ÷ 12).
* Outstanding principal (or average balance) is what interest is applied to; as principal changes, so does interest assessed.

Simple vs. compound interest

• Simple interest: charged only on the original principal. Common in some short-term loans.
• Compound interest: charged on principal plus accumulated interest. Most savings accounts and many loans use compounding.
• For savers, compounding increases returns (interest on interest).
• For borrowers, compounding (especially if capitalized into principal) can increase the total amount owed.

Tip: Use the Rule of 72 to estimate doubling time: 72 ÷ annual interest rate ≈ years to double (e.g., 72 ÷ 4% ≈ 18 years).

Common uses of interest

• Credit cards — often carry high APRs; balances can grow quickly if only minimum payments are made.
• Mortgages — long-term loans with fixed or variable rates; interest dominates early payments.
• Auto loans — typically shorter-term with fixed rates.
• Student loans — rates and rules vary; some policy actions have temporarily paused interest.
• Savings accounts and CDs — pay interest to depositors; compounding frequency matters.
• Invoices — some businesses assess interest on late payments instead of a flat late fee.

Pros and cons of paying interest (for borrowers)

Pros
* Provides access to needed capital (home, car, education, business) when you can’t or prefer not to pay cash.
* Can help build a credit history when payments are made on time.
* Leverage can magnify returns when borrowed funds generate higher returns than the borrowing cost.

Cons
* Interest is a recurring cash outlay and may be paid before principal reduction.
* Can compound and become difficult to manage if debt grows.
* High debt burdens reduce financial flexibility and future borrowing capacity.

Pros and cons of collecting interest (for lenders/investors)

Pros
* Regular income stream — potentially passive and predictable if borrowers are reliable.
* Efficient use of idle capital compared with leaving it uninvested.

Cons
* Interest income is taxable.
* Risk of borrower default; lending can produce lower returns than alternative investments.
* Charging interest can be controversial in some contexts (e.g., high student loan rates).

Interest and macroeconomics

Central banks (like the U.S. Federal Reserve) set policy rates that influence broad market interest rates. Lower policy rates tend to:
* Make borrowing cheaper and stimulate spending and investment.
* Reduce returns on savings and some investments.

Higher policy rates:
* Make borrowing more expensive and can slow demand and inflation.
* Increase yields on savings and fixed-income investments.

Policy rate changes ripple through mortgages, car loans, credit cards, and the broader economy.

Accrued interest

Accrued interest is interest that has been incurred but not yet paid. For borrowers it’s owed but unpaid; for lenders it’s earned but not yet received. Accruals commonly appear on financial statements.

How to earn interest wisely

• Understand the borrower or instrument’s risk before lending or investing.
• Compare APR versus effective annual yield—compounding frequency matters.
• Use insured bank products (FDIC/NCUA) for safety if principal protection is a priority.
• Consider laddering CDs or using diversified fixed-income instruments to manage rate and reinvestment risk.

Bank account interest rates

Deposit rates vary with central bank policy and market conditions. When policy rates are low, savings yields tend to be low; when policy rates rise, bank deposit rates typically increase. Comparison-shop among banks, credit unions, and online banks for better yields.

Bottom line

Interest is a fundamental mechanism in finance that facilitates borrowing and lending, allocates capital, and influences economic activity. Understanding the type of interest (simple vs. compound), how it’s calculated, and how macroeconomic policy affects rates helps people make better borrowing, saving, and investing decisions.