Interest 101: Explaining What It Is and Impact on Borrowers and Savers
A tricky topic simplified. Pretty much all you need to know about interest.
- Interest can be either a form of income (when lending) or an expenditure (when borrowing from others).
- As a borrower, you will owe the amount that you originally borrowed, plus interest.
- As a lender, you will earn periodic interest payments when lending money or depositing money into an interest-bearing bank account.
- Compound interest is the interest earned on top of previous interest and can massively boost your savings fund over a long period. The reverse is true when you are borrowing.
Interest is defined as the cost of borrowing money. In this introductory article, you will learn about interest before exploring both the owing and earning sides of interest.
Calculating Interest
Interest is calculated as a percentage of the amount borrowed. This percentage is then regularly paid to the lender. Usually, it is calculated annually but can also be declared at shorter or longer intervals.
Interest When Borrowing
If you have taken a loan, the lender is taking a risk in lending money to you. While the money is with you, the lender cannot use those funds for potentially more beneficial use, incurring what’s known as opportunity cost.
As such, you will have to repay more than you borrowed. You’ll have to return the amount that you borrowed initially and the interest as compensation to the lender. The interest rates you pay on loans reflect your credit risk, which is the likelihood of you not paying back the loan. The likelier you are to pay back the loan, the lower the rates you’re charged (all other things equal).
Note - the definition of opportunity cost is the loss of other alternatives when one alternative is chosen.
Interest When Lending
Consider depositing any savings or spare funds in an interest-generating savings account or lend it out yourself in return for interest payment. Not all lending provides the same level of return! It depends on several factors, such as:
- The interest rates on offer, also known as the going interest rate
- How much are you lending?
- The length of time for repayment
Most banks and credit card issuers do not calculate interest owed or earned using the simple interest method, but rather, they use compound interest. As such, it is important to know the difference between simple and compound interest!
Simple interest
Simple interest is regarded as a one-time fee for a loan or income earned on deposits. It is calculated as a percentage of the original sum of money loaned (the principal amount).
Principal × Rate × Time=Interest
For example, if you have a $200 deposit, an Interest Rate of 5 per cent and a loan period of 3 years, the interest will be:
$200 × 0.05 × 3= $30 for 3 years
Compound interest
Simply put, compound interest is the interest earned on top of interest. Interest is added to the principal at the end of the compounding period (e.g. annually or monthly). The interest is calculated on a greater amount than the original principal in the following compounding period.
Fun fact: Albert Einstein is said to have once labelled compound interest as the eighth wonder of the world! Some are doubtful as to whether he said it or not. However, there is no doubting the fact that compound interest can seriously boost your savings. Benjamin Franklin, one of the Founding Fathers of the United States and still appears on the US $100 bill, said it even better: "Money makes money. And the money that money makes, makes money."
This is probably the easiest way of getting rich! By keeping hold of and reinvesting money earned through interest, savings can build momentum — meaning you’ll be earning interest on top of interest. Free money!
Visualising Compound Interest
Imagine your savings pot as your garden, which hopefully will blossom magnificently. We’ll imagine your money as a flower (because it doesn’t grow on trees), in this case, sunflowers, which work for you! Periodically, these sunflowers produce seeds, which produce more sunflowers, and as a result, your garden grows.
Let’s say you start with 100 sunflowers; over the first year, they produce enough seeds to grow 10 more. At the start of year 2, you’ve got 110 sunflowers. Because of your 10 additional sunflowers, the crop now produces enough seeds to grow 11 more sunflowers that year.
If your crop of sunflowers had non-compounded growth, you would add 10 sunflowers per year, every year. This would result in you doubling (200) your amount of sunflowers in 10 years, tripling (300) it in 20, and having 400 sunflowers after 30 years.
However, your crop has compounding growth, so each new sunflower works to produce seeds to create additional sunflowers, who each work to produce more seeds, and so on…
As a result, your crop doubles in 7 years (compared to 10), grows to 400 in 15 years (compared to 30) and grows to 1,750 sunflowers after 30 years, which is greater than 4 times better than under the “non-compounded” crop.
It’s never too late to enjoy the benefits of compound interest, especially if you’re reading this as a young adult. If that’s you, you’re at an age where earning compound interest can have a significant impact over the decades to come.
Start Investing as Young as Possible
UNDERSTANDING INTEREST RATES AND DEBT. COMPLETED. ✅
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