Interest is the cost of borrowing money — what you pay to borrow someone else’s or what you charge those to whom you lend.
People don’t like to just share, especially if they are not sure they will get their loan back – that is why interest exists. Lenders can feel confident parting with their money for a while and taking on all the dangers that goes along with it when they receive interest.
What is interest?
The cost of borrowing money is known as interest and is typically stated as a percentage. Interest rates change over time, and a variety of factors determine the particular rate you might earn or pay. The going rates of the day, which are determined by the interest rate the Federal Reserve, the nation’s central bank, charges other banks to borrow money, are a crucial factor to take into account. In order to promote economic growth and combat unemployment, the Federal Reserve frequently reduces interest rates; conversely, when the economy is doing well, it rises rates.
Your lender will also take your borrower risk into account when setting your specific rate.This includes elements like your credit history, the amount of debt you are carrying relative to your income, and any troubling financial incidents from the past, such bankruptcies. Different methods of calculating interest might be used, but they all serve the same objective: to give the lender confidence to lend you money in light of the opportunity cost and risks associated.
How does it work?
Four factors determine how much interest you pay (or make, if you’re the lender):
1. The sum of money being lent
2. How long it will be lent for (the length of the loan)
3. How frequently is interest calculated (daily, monthly, annually, etc.)
4. The rate of interest
Given that interest is determined as a proportion of the loan amount, your interest payment will generally increase with the amount of borrowing. In general, borrowing will cost more the longer you keep the loan because interest can accrue more slowly.
The frequency of interest calculations affects how much money you owe overall as well. The general rule is that the ultimate sum will be bigger the more frequently interest is calculated. Therefore, even if the initial loan amount and period are the same, 3% computed monthly will result in a higher interest rate than 3% calculated annually.
The most popular method of calculating interest in consumer finance is the annual percentage rate, or APR. This is probably the figure you’ll see when applying for a credit card, auto loan, or mortgage, expressed as a percentage. APR typically covers all annual expenses related to the loan in addition to interest. Therefore, the $10 arrangement fee that a payday lender imposes will undoubtedly be reflected in the APR.
APY (Annual Percentage Yield) is also expressed annually, but unlike APR, it also factors in how often interest is calculated. So if your interest rate is 3% annually, with no additional fees, your APY is 3%. If your interest rate is 3% calculated monthly, then your APY is actually 3.04%.
(The formula for APY is (1 + r/n)^n – 1 where r is the interest rate and n is how often interest is calculated.)
Simple vs Compound Interest
Simple interest is calculated by multiplying the interest rate by the principal (or the original amount borrowed). Compound interest is calculated by multiplying the interest rate by the principal plus any unpaid interest. As a result, the more frequently interest is calculated or compounded, the more interest is paid or earned in total.
How is interest calculated?
Let’s discuss an example, taking into consideration four key factors:
1. The amount of money being borrowed, also known as principal (P)
2. The length of the loan (t)
3. How often interest is calculated (n)
4. The interest rate (i)
For example, you take out a $2,000 loan (P) for two years (t) at a rate of 3% (i). There is no compounding, so you can use the simple interest formula:
So it will be: $2,000(1+(0,03*2)) = $2120
At the end of two years you would owe $2120 — That’s the $2000 principal plus $120 of interest.
Now imagine the 3% compounds monthly, so the formula for compound interest is:
P(1 + i/n)^nt
Then the answer will be:
$2000 (1 + 0,03/12)^(12*2) ~ $2123,5
Good interesting rate
An exact definition of a “good” interest rate is not known. Lenders typically seek the highest rate available, but borrowers typically want the lowest. Your ability to obtain a rate will be influenced by a number of elements, including your creditworthiness and current market rates.
How can you tell if an interest rate is good if it is offered to you? Examining typical market prices is a fantastic place to start. For instance, you can discover the most recent rates for a range of goods utilizing Bankrate.com.