Interest: Definition and Types of Fees For Borrowing Money

What Is Interest?

Interest is the monetary charge for the privilege of borrowing money. Interest expense or revenue is often expressed as a dollar amount, while the interest rate used to calculate interest is typically expressed as an annual percentage rate (APR). Interest is the amount of money a lender or financial institution receives for lending out money. Interest can also refer to the amount of ownership a stockholder has in a company, usually expressed as a percentage.

Understanding Interest

Interest is the concept of compensating one party for incurring risk and sacrificing the opportunity to use funds while penalizing another party for the use of someone else's funds. The person temporarily parting ways with their money is entitled to compensation, and the person temporarily using those funds is often required to pay this compensation.

When you leave money in your savings account, your account is credited interest. This is because the bank uses your money and loans it out to other clients, resulting in you earning interest revenue.

The amount of interest a person must pay is often tied to their creditworthiness, the length of the loan, or the nature of the loan. All else being equal, interest and interest rates are higher when there is greater risk; as the lender faces a greater risk in the borrower not being able to make their payments, the lender may charge more interest to incentivize them to make the loan.

History of Interest Rates

This cost of borrowing money is considered commonplace today. However, the wide acceptability of interest became common only during the Renaissance.

Interest is an ancient practice; however, social norms from ancient Middle Eastern civilizations, to Medieval times regarded charging interest on loans as a kind of sin. This was due, in part because loans were made to people in need, and there was no product other than money being made in the act of loaning assets with interest.

The moral dubiousness of charging interest on loans fell away during the Renaissance. People began borrowing money to grow businesses in an attempt to improve their own station. Growing markets and relative economic mobility made loans more common and made charging interest more acceptable. It was during this time that money began to be considered a commodity, and the opportunity cost of lending it was seen as worth charging for.

Political philosophers in the 1700s and 1800s elucidated the economic theory behind charging interest rates for lent money, authors included Adam Smith, Frédéric Bastiat, and Carl Menger.

Iran, Sudan, and Pakistan use interest-free banking systems. Iran is completely interest-free, while Sudan and Pakistan have partial measures. With this, lenders partner in profit and loss sharing instead of charging interest on the money they lend. This trend in Islamic banking—refusing to take interest on loans—became more common toward the end of the 20th century, regardless of profit margins.

Today, interest rates can be applied to various financial products including mortgages, credit cards, car loans, and personal loans. Interest rates started to fall in 2019 and were brought to near zero in 2020.

Formula and Calculation for Interest

In its most basic form, interest is calculated by multiplying the outstanding principal by the interest rate.

Interest = Interest Rate * Principal or Balance

The more complex aspect of calculating interest is often determining the correct interest rate. The interest rate is often expressed as a percentage and is usually designated as the APR. However, calculating the APR often does not reflect any effects of compounding. Instead, the effective annual rate is used to express the actual rate of interest to be paid.

Often, an annual rate must be converted to calculate the applicable interest earned in a given period. For example, if a savings account is to pay 3% interest on the average balance, the account may award 0.25% (3% / 12 months) each month.

The applicable interest rate is then multiplied against the outstanding amount of money related to the interest assessment. For loans, this is the outstanding principal balance. For savings this is often the average balance of savings for a given period.

In either case, the amount of interest assessed each period will likely change. For loans, borrowers will have likely made payments that reduce the principal balance, resulting in lower interest. For savers, general activity (including the addition of last month's interest) often changes the applicable balance.

Simple Interest vs. Compound Interest

Two main types of interest can be applied to loans—simple and compound. Simple interest is a set rate on the principal originally lent to the borrower that the borrower has to pay for the ability to use the money. Compound interest is interest on both the principal and the compounding interest paid on that loan. The latter of the two types of interest is the most common.

For obvious reasons, individuals attempting to earn interest prefer compound interest agreements. This agreement results in interest being earned on interest and results in more total earnings. Savings accounts with banks often earn compound interest; any prior interest earned on your savings is deposited into your account, and this new balance is what earns interest in future periods.

On the other hand, compound interest is extremely concerning for borrowers especially if their accrued compound interest is capitalized into their outstanding principal. This means the borrower's monthly payment will actually increase due to now having a greater loan than what they started with.

Common Applications of Interest

There's countless ways a person can charge or be charged interest. Below are some common examples of where interest may be earned by one party and paid by another.

• Credit cards: Among the methods of borrowing money that incurs the highest amount of interest, credit cards are known for having a high APR. Consumers may make minimum monthly installment payments; in return, interest expense may accumulate and is earned by the credit card providers/underlying financial institutions.
• Mortgages: Among the longest-term loans, mortgages often incur interest over the entirety of their potential 30-year term. Though interest may be assessed as a fixed or variable rate, it is theoretically reduced over time as the borrower pays down the original loan principal amount.
• Auto loans: An example of a shorter-term loan, auto loans are often awarded for terms up to six years. Interest is often charged as a fixed rate, and the dealership extending credit may have an in-house financing department that collects the interest revenue.
• Student loans: During COVID-19, student loan payments were paused, and prevailing loan rates were dropped to 0%. This meant that for a while, all loans incurred no interest assessments.
• Savings accounts: Often a positive type of interest for most consumers, savings accounts earn monthly interest assessments. Also called dividends, consumers have these deposits are automatically credited to your account.
• Invoices: Though many companies may assess a late fee, some companies choose to assess an interest charge on outstanding and late invoices. The idea is since the late payer is technically borrowing money from the invoice holder, the invoice holder is due interest.

Advantages and Disadvantages of Paying Interest

Imagine a situation where you absolutely need reliable transportation to get to work. There is no public transit system, you do not own a car, work is far away, and you can't afford to buy an entire car outright. The largest advantage of paying interest is it is a relatively low expense compared to alternatives.

Paying interest also means a payer is holding debt, building their credit history, and potentially effectively using leverage. For example, real estate developers often borrow money to construct and rent buildings. If the rate of return on the building is greater than the interest rate they are charged, the company is successfully using someone else's money to make money for themselves.

On the downside, interest is a recurring cash expense. Payers are often contractually obligated to pay interest, and monthly payments are typically applied to interest assessments before paying down the principal. Consumers may find interest assessments overwhelming. In addition, having too many loans and too high of monthly payments may restrict a borrower from being able to take out more credit.

Advantages and Disadvantages of Collecting Interest

A strategy for many investors is to collect interest. Often a fixed amount (or at least consistent), interest often provides positive cash flow that is a reliable source of income depending on the creditworthiness of the person borrowing the money. Instead of having capital sitting around and not being used, lending money to others is a more efficient way of deploying capital, especially in the short term when the lender may need that money for a specific reason in the longer term.

Interest is also touted as one of the simplest forms of passive income. Loans may require little to no administration or maintenance after the agreement is signed. Lenders may simply collect interest and principal payments.

There are some downsides to collecting interest. First, interest revenue is taxable; even a small amount may push a taxpayer into a higher tax bracket. Next, because you are collecting interest, this means you are allowing someone else to use your capital. Though you may be satisfied collecting interest, there will often be greater earning potential had you utilized the capital yourself.

Also, collecting interest may have philosophical opponents. Consider student loan debt assessments. While some say interest rates near 10% are reasonable for the amount of risk these lenders are incurring, others claim these rates are predatory to young adults and should not be assessed.

Interest and Macroeconomics

A low-interest-rate environment is intended to stimulate economic growth so that it is cheaper to borrow money. This is beneficial for those who are shopping for new homes, simply because it lowers their monthly payment and means cheaper costs. When the Federal Reserve lowers rates, it means more money in consumers' pockets, to spend in other areas, and more large purchases of items, such as houses. Banks also benefit from this environment because they can lend more money.

However, low-interest rates aren't always ideal. A high-interest rate typically tells us that the economy is strong and doing well. In a low-interest-rate environment, there are lower returns on investments and in savings accounts, and of course, an increase in debt which could mean more of a chance of default when rates go back up.

In response to COVID-19, the Federal Reserve began enacting monetary policy as early as March 2020. Then, as the pandemic eased, the Federal Reserve began raising the Federal funds rate. As this Federal funds rate influences the interest rate on many other types of loans, borrowers soon found it to be more expensive to incur debt.

The Bottom Line

Interest is a critical part of our high-functioning society. By allowing individuals to borrower and lend money, society has greater economic prosperity by encouraging spending. As a result, capital likely does not sit around idly; it is borrowed by some and lent by others. Through the payment of interest, individuals are encouraged to always be putting money to use.