Interest

Interest summary:

• Interest is money you earn on funds in a bank account.

• Lenders charge interest when you receive borrowed money, and credit card companies charge interest when you carry a balance forward.

• Interest can be simple or compounded. Compounding increases the interest that you receive or pay.

Interest Definition and Meaning

Interest is either the cost of borrowing or the payment for investing money.  You earn interest when you keep money in a bank account, such as a savings account or certificate of deposit (CD). When you borrow money, for instance with a loan or credit card, interest is money you pay the lender or credit card issuer.  

Types of Interest

Banks pay interest on deposits and charge interest for loans. Interest can be simple or compound.

Simple interest is based only on the amount deposited or borrowed. If you deposit $1,000 at 10% for a year, you'll get back $1,100 in 12 months. 

Compound interest is calculated at regular intervals during the loan term. If your $1,000 deposit is compounded monthly, your interest after the first month is $8.33, based on a $1,000 balance. The next month, your interest would be based on a balance of $1,008.33. After 12 months, you'd get back $1,104.71. Put another way, compound interest is interest on interest. 

Interest can also be fixed or variable (also called adjustable).  

Fixed interest rates don't change. A certificate of deposit, or CD, usually pays the same rate for the time your deposit is locked up. Most mortgages and auto loans charge the same interest rate until you pay off the balance. 

Other loans charge variable interest, which means your interest rate can rise and fall while you're paying off your debt. Credit card interest rates are typically variable and are tied to economic markets. 

Variable interest debt can be trickier to pay off because your payments can be unpredictable. But in some cases, variable interest can work to your benefit. That’s because market conditions could cause the interest rate on your debt to fall, leaving you with lower payments. 

Comprehensive Breakdown of Interest

Interest is money you can earn by depositing money into an interest-bearing account, like a savings account or CD (and sometimes a checking account). In a savings account, the amount of interest you earn on your money can change over time, and even from one day to the next. With a CD, you lock in a fixed interest rate until it matures. 

If you’re earning interest, it's best to try to secure the highest rate possible. When paying interest, shop around for the lowest rate you can find. People with higher credit scores generally pay lower interest rates when they borrow.

You may also be able to negotiate better interest rates on the credit cards you already have.  That would make your monthly payments less expensive and help you pay off your debt sooner. Credit card issuers may work with you if you have a strong credit history and an account in good standing.

If your lender won't negotiate the interest rate on your loan, you can try refinancing into a new loan with a lower interest rate to save money. 

Examples of Interest

If you deposit $100 in a savings account with a 4% interest rate, and your bank compounds interest once a year, after 12 months, you'll earn $4, assuming your 4% interest rate doesn't change during that time. 

Many loans are compounded monthly. If you have a three-year $5,000 loan with a fixed 8% interest rate that's compounded monthly, you'll pay a total of $641 in interest.