What Does Interest Do for Borrowing and Saving?
Explore the core principles of interest and its dual impact on your finances, from borrowing costs to savings growth.
Interest is a fundamental concept in personal finance, acting as the cost of borrowing money or the reward for lending it. It is a percentage of the principal amount—the original sum borrowed or deposited. Understanding how interest operates is important for managing financial decisions, whether you are taking out a loan or growing your savings. Interest charges or earnings significantly impact the total amount repaid on debt or the total accumulation in savings over time.
The Fundamental Role of Interest
Interest serves several purposes in the financial system, primarily compensating for the time value of money. The time value of money principle states that a dollar today is worth more than a dollar in the future. This is because money available now can be invested and has the potential to earn a return.
Interest also accounts for the risk a lender takes by providing funds, as borrowers may not repay the loan. Lenders also factor in inflation, which is the general increase in prices and the corresponding decrease in the purchasing power of money over time. Interest helps compensate for the erosion of money’s value due to inflation, ensuring that the return on a loan or investment maintains its real value.
Interest in Borrowing
When you borrow money, interest represents the cost you pay to use someone else’s funds. This additional amount is paid back to the lender on top of the original principal amount borrowed. For instance, loans like mortgages, car loans, and personal loans all involve interest charges.
The total cost of borrowing is often expressed as an Annual Percentage Rate (APR), which includes the interest rate and certain fees associated with the loan. For example, if you borrow $10,000, and the interest and fees amount to $2,000, you will repay $12,000 over the loan’s term.
Interest in Saving
Conversely, when you save or invest money, interest is the reward you earn for allowing a financial institution to use your funds. This earning helps your money grow over time without requiring additional deposits from you. Common examples include savings accounts, money market accounts, and Certificates of Deposit (CDs).
The earnings on savings accounts are often described by the Annual Percentage Yield (APY), which takes into account both the stated interest rate and how frequently the interest is added to your balance. A higher APY means your savings will grow more quickly.
How Interest is Calculated
Interest is calculated in one of two ways: simple interest or compound interest. Simple interest is calculated only on the original principal amount. For example, if you deposit $1,000 at a 5% simple interest rate annually, you would earn $50 each year.
Compound interest, on the other hand, is calculated on the principal amount plus any accumulated interest from previous periods. This “interest on interest” effect allows your money to grow at an accelerated rate. For savers, compounding means that the interest earned in one period also earns interest in subsequent periods, leading to significant growth over time. For borrowers, particularly with credit cards, compound interest can increase the total debt more rapidly if balances are not paid in full.