When used in the context of loans and credit, interest is the added amount of money charged when you take out a form of credit, like a loan. Interest is in addition to the base loan price, and it is like a fee you pay for borrowing money. It's the way banks, credit unions, and other institutions make money on loans. Interest is expressed as a percentage and varies based on different loans.
There are two kinds of interest, simple interest, and compound interest. Simple interest is a set percentage of the loan amount you have to pay periodically. Compound interest is a percentage you have to pay on the base amount + any previous interest. Different kinds of loans have different forms of interest, so it's hard to generalize which loans use which interest.
Here’s an example of a simple interest loan. Compound interest is more complicated, so I’ll dedicate an entire coming article to it.
Let's say you take out a $1000 loan with a simple interest rate of 5% over 5 years. This means that over 5 years, you have to pay back both the $1000 loan and the $50 (5% of 1000) interest.
To find the amount we pay every month, first, we divide the total amount by the number of years:
$1000/5 = $200 per year to cover the base loan, and $50/5 = $10 per year to cover interest.
Then, we divide by 12 (12 months in a year) to get the monthly payment.
$200/12 = $16.66 per month to cover the base loan, and $10/12 = $0.83 per month to cover
interest.
So, you pay $16.66 a month to cover the loan amount and an additional $0.83 per month to cover the interest, for a total of $17.50 a month for 5 years. This means at the end of 5 years, you will have paid the $1000 base loan amount + the 5% interest, for a total of $1050. So, while the loan may have been for only $1000, the actual amount you paid was more.
Mortgages and car loans generally have interest rates under 10%. Credit cards have much higher interest rates when you don't pay off your balance on time, with rates ranging from 10% - 25%. Remember, you only pay interest on a credit card if you don’t pay off your balance (the amount you owe) on time.
You’ll be charged interest on any kind of loan, so when you finance a car, get a mortgage to buy a home, or take out a student loan, you’ll be charged interest. Interest varies on a few factors, the main factor being your credit. If you have a higher credit score, you're generally charged less interest. The worse your credit score, the more interest you're charged. This leads us into an odd situation. You build credit by paying off loans but to get loans, you need to have credit. I’ll explain how to start building credit even when you’re under 18 in a coming article.
Another factor that determines interest rates is the Federal Reserve (the literal bank of America). The Federal Reserve determines a baseline interest rate using a mix of factors. Banks and other institutions then build off of that rate to determine the interest rate their safest customers (those with higher credit scores and a history of paying off loans on time) will pay. This rate is called the prime rate and is generally the lowest possible interest rate a normal person can get. While the Federal interest rate is for short term loans, it dictates the prime rate, which in turn dictates interest rates for mortgages, car loans, and credit cards. The current Federal Fund rate ranges from 0% to 0.25%.
You may be wondering, “Why does interest exist?”. Well, interest exists because money itself has value. Generally, loans are taken out when you don’t have enough money to purchase an item. You borrow from an institution (banks, credit unions, etc), who have lots of money. Well, just like any other service, the bank can't let you borrow money for free. First, it's their money that they're willing to give to you. Additionally, they're taking the risk that you’ll never return their money. Also, by loaning out that money, they themselves cannot use it. In order to make money, and compensate for the risk, banks and other institutions charge interest.
Interest is a basic part of any kind of loan, and a factor that can drastically change the way you look at purchases like buying a car. Accounting for interest is extremely important when using credit.