What Is Interest?

What Is Interest?

Let me tell you directly: interest is the charge you pay for borrowing money, usually expressed as a percentage of the principal amount you've borrowed. For lenders like me or any financial institution, it's the compensation we get for temporarily giving up our funds.

When we talk about interest expense or revenue, it's often in dollar terms, but the rate we use to calculate it is typically an annual percentage rate, or APR. It's also what a lender earns for lending out money. Sometimes, interest refers to the ownership stake a stockholder has in a company, expressed as a percentage.

Understanding Interest

Interest compensates one party for taking on risk and giving up the chance to use their funds, while it penalizes another for using someone else's money. If you're the one parting with your money temporarily, you're entitled to that compensation, and if you're using those funds, you often have to pay it.

When you leave money in your savings account, your account earns interest because the bank uses your money to loan to others, and you get interest revenue from that. The interest you pay is often linked to your creditworthiness, the loan length, or the loan type. All else equal, higher risk means higher interest and rates, as the lender charges more to offset the chance you might not repay.

History of Interest Rates

The idea of interest as the cost of borrowing is common today, but it only became acceptable during the Renaissance. Interest has ancient roots, yet social norms in ancient Mediterranean, Middle Eastern, and Medieval European civilizations saw charging interest on loans as a sin or usury.

Before Christianity, Greeks and Romans thought making money from money was unnatural, as Aristotle argued in his Politics. He distinguished proper economic relations for household needs from the unnatural love of money where wealth becomes its own end through trade and interest. He was especially critical of usury, meaning any interest, not just excessive amounts.

These views carried into Islam and Catholic Scholasticism, making usury a sin. Lenders were seen as profiting from others' misfortunes. But during the Renaissance, starting in Italy, this changed as people borrowed to grow businesses, making interest more acceptable. Money became a commodity, and lending had an opportunity cost worth charging for.

Philosophers like Adam Smith, Frédéric Bastiat, and Carl Menger later explained interest as legitimate compensation for risk and opportunity cost. Islam still bans interest, called riba, using profit-sharing instead. Today, interest applies to mortgages, credit cards, car loans, and personal loans, with central banks like the Federal Reserve using rates for monetary policy.

Rates fluctuated recently: they fell in 2019, hit near zero in 2020 due to COVID-19, rose to fight inflation, and started cutting in 2024 as inflation eased and hiring slowed.

Formula and Calculation of Interest

In its basic form, you calculate interest by multiplying the outstanding principal by the interest rate: Interest = Interest Rate × Principal or Balance.

The tricky part is getting the right interest rate, often expressed as a percentage like APR, but APR doesn't always account for compounding—use the effective annual rate for that. You might need to convert an annual rate for a specific period, like dividing 3% by 12 for monthly interest on a savings account.

Multiply that rate by the outstanding amount, which changes over time—for loans, as you pay down principal, interest drops; for savings, the balance shifts with activity and added interest. Your credit score heavily impacts the rate you're offered on loans and credit lines.

Simple Interest vs. Compound Interest

There are two main types: simple interest is a fixed rate on the original principal that the borrower pays to use the money. Compound interest is on the principal plus any previously earned interest, which is more common.

If you're earning interest, you want compound agreements because they earn interest on interest, leading to more total earnings—savings accounts often work this way. For borrowers, compound interest can be problematic if it capitalizes into the principal, increasing monthly payments.

Common Uses of Interest

Interest appears in many places: credit cards have high APRs, with minimum payments leading to accumulated interest for providers. Mortgages incur interest over up to 30 years, reduced as principal is paid down. Auto loans, up to six years, often have fixed rates collected by dealerships.

Student loans paused payments and dropped rates to 0% during COVID-19. Savings accounts earn interest, credited monthly. Some companies charge interest on late invoices instead of fees. A quick tip: use the rule of 72 to estimate doubling time—divide 72 by the rate; at 4%, it's about 18 years.

Advantages and Disadvantages of Paying Interest

If you need something like a car for work and can't buy it outright, paying interest is a low-cost option compared to alternatives. It builds your credit history and lets you use leverage, like developers borrowing to build and rent properties for profit if returns exceed interest.

On the downside, it's a recurring expense, paid before principal, and too much can overwhelm you or limit more borrowing. Pros include access to needed capital, credit building, and leveraging for profits; cons are cash outlays, priority over principal, potential compounding overload, and contractual obligations.

Advantages and Disadvantages of Collecting Interest

Collecting interest provides reliable income based on the borrower's creditworthiness—it's efficient use of capital rather than letting it sit. It's passive, with little maintenance after the agreement, just collecting payments.

Drawbacks include tax liability on interest, potentially lower returns than using the capital yourself, and philosophical issues like high rates on student loans seen as predatory. Pros are cash flow, passivity, consistency if reliable, and better than idle capital; cons are taxes, opportunity costs, and negative perceptions in some cases.

Interest and Macroeconomics

Low rates stimulate growth by making borrowing cheap, helping homebuyers and banks lend more. High rates signal a strong economy but mean lower investment returns and higher default risks when rates rise.

The Fed adjusted rates during COVID-19, raising them post-pandemic to fight inflation, then cutting in 2024 as conditions improved, affecting all borrowing from mortgages to credit cards.

What Is Accrued Interest?

Accrued interest is interest incurred but not paid—for borrowers, it's due but not remitted; for lenders, it's earned but unpaid, often part of financial statements.

What Is the Best Way to Earn Interest?

Deposit into interest-generating investments, but research the borrower's risk; if they default, you might lose principal without recourse.

How Much Interest Do Bank Accounts Pay?

It varies with government rates and conditions—near 0% during low fed funds rates in the pandemic, then higher as rates rose to curb inflation.

The Bottom Line

Interest is vital for capitalist economies, enabling borrowing and lending to boost prosperity and encourage spending. Capital gets used rather than idled, with interest motivating that cycle.