Nov 15, 2022

What is Interest and How Does it Work?

What is Interest, how does it work and how it affect you? Read more in this blog.

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What is Interest?

Interest is what you pay when you borrow money. Interest is paid by the borrower and given to the lender.

How Does Interest Work?

Interest is the cost of borrowing money. When you borrow money, you get debt and have to pay interest. When you let someone else use your money, like a bank, you give them credit and get interest in return. Most of the time, the amount you pay or get is given as an annual rate, but it doesn't have to be that way.

Because of interest, you have to pay back more than the original loan balance or deposit. In other words,  you will end up paying back more than you borrowed. Subsequently,  lenders make money off of interest payments.

Say you buy a car, you will owe the amount of the loan (also called the "principal") plus the interest that the lender charges. If your car loan is for $15,000 and the interest is 6%, you'll have to pay back the $15,000 plus 6% of $15,000, which is $900. In total, you'll have to pay back $15,900. The length of time you will have to How long you have to pay this amount back will be up to your lender. You can earn interest if you put money into a savings account.

For example, Jack deposits $5,000 in a savings account that pays a 5% interest rate. With simple interest, he’d earn $250 over one year. To calculate:

Multiply $5,000 in savings by 5% interest.

$5,000 x .05 = $250 in earnings (see how to convert percentages and decimals).

Account balance after one year = $5,250.

There are numerous methods for calculating interest, some of which are more advantageous for lenders. The decision to earn interest depends on the other possibilities available for investing your money, just as the decision to pay interest depends on what you receive in return.

Interest Payments When Borrowing

You must pay back whatever money you borrow in order to borrow it. You must also pay back more than you borrowed in order to make up for the risk and trouble the lender took by lending to you. The longer you wish to borrow the money and the riskier you are to the lender, the more interest you'll have to pay.

Interest Payments When Lending

If you have excess cash on hand, you can invest it yourself or deposit the money in a savings account, giving the bank the opportunity to lend it out or invest it. You'll expect to receive interest in return. There is little benefit to waiting if you are not going to make anything, so you could be tempted to spend the money instead.

The interest you earn will vary depending on who you lend money to and how long they intend to use it for, just like the interest you pay on loans. You may withdraw your money whenever you want from a savings account because it is federally insured and there is no danger. Because of this, savings account interest rates are substantially lower than those of other interest-bearing instruments.

Do You Have To Pay Interest?

When you borrow money, you are often responsible for paying interest on that money. However, due to the fact that there is not always a line-item transaction or a separate bill for interest costs, this may not be immediately apparent.

Interest on Installment Debt

The interest charges on loans such as regular mortgages, auto loans, and student loans are already factored into the monthly payment amount. One component of each payment you make goes toward paying down the principal balance of your debt, while the remaining portion goes toward paying the interest on that loan. You can use these loans to make payments toward the reduction of your debt over a predetermined period of time ( four-year car loan, for example).

Read more: 10 Easy Ways To Manage Your Money Better

Interest on Revolving Debt

Other loans are revolving. What are revolving loans? It means you can borrow additional money each month and pay it back over time. For instance, credit cards let you make repeated purchases as long as you don't go over your credit limit.

Calculations of interest can differ. To understand how interest is calculated and how your payments are made, consult your loan agreement or speak with the lender.

Read more: How to Choose Your First Credit Card?

The Annual Percentage Rate (APR) - Not Interest but still an Additional Cost To Consider

Loan quotes usually have an annual percentage rate (APR). This figure indicates your annual payment and may also reflect expenses other than interest rates. The interest rate is the total cost of borrowing (not the APR). Some loans require you to pay finance charges or closing expenses, which are technically not interest charges but are determined by the size of your loan and your interest rate. Knowing the distinction between an interest rate and an APR would be helpful. 

What's the distinction?

APR represents the total yearly cost of a loan to the borrower, including all fees. The APR is stated as a percentage, just like an interest rate. It does, however, contain other costs or fees such as mortgage insurance, the majority of closing costs, discount points, and loan origination fees, unlike an interest rate.

Read more: Is It Worth It to Have Renter's Insurance?

How is Interest Earned?

When you lend money or put money into an interest-bearing bank account, like a savings account, you receive interest. When you make an account deposit, the bank handles the lending on your behalf; they invest your money and utilize it to lend to other customers. The banks pass along a percentage of their profits to you in the form of interest when they make money.

The bank will periodically pay interest on your savings (every month or every three months, for example). Your account balance will rise, and you'll see a transaction for the interest payment. You have two options with that money: either spend it or leave it in the account to continue earning interest.

By leaving the interest in your account, your savings can really take off. Both the initial deposit you made and the money that is applied to your account are subject to interest. "Compound interest" is the practice of earning interest on top of prior interest.

What are the interest rates right now?

 At its September meeting, the Federal Reserve announced it would raise the target range for the federal funds rate, which most interest rates are based on, by 0.75 percentage points, to 3 to 3.25 percent. The Fed is still trying to stop inflation from getting so high that it sets a new record. In March, the Fed raised interest rates for the first time since 2018. During the COVID-19 pandemic, the Fed has kept its target interest rate close to zero.

How does raising interest rates help inflation?

The cost of borrowing money rises as interest rates rise. Theoretically, less people and companies will borrow money, which should result in a slowdown in economic activity. In other words, demand is cooled by rising interest rates. Businesses won't be able to raise prices when the demand curve moves and there is less demand for products and services, which will cause inflation to slow.

Why is the federal funds rate so influential on other interest rates?

Other interest rates are impacted by the fed funds rate because it decides whether banks can make more money lending to one another or to different borrowers. It will be advantageous for banks to lend to others when the fed funds rate is very low. Even while other rates will increase when the fed funds rate increases, fewer individuals and companies will apply for loans at such high rates, slowing down open market lending. The cycle will eventually be continued by the Fed lowering the funds rate once again as a result of this.

Read more: 5 Credit Card Mistakes to Avoid During Tough Times

Work with Vincere Wealth to Build Your Wealth

The benefit of a great fee-only advisor is not their ability to "beat" the market, but rather their ability to keep you on track with your financial goals. At Vincere, they will want to know what you value, what keeps you up at night, your goals and aspirations, and then we'll work backwards to determine what investments are required for your particular situation.

To overcome the challenges of diversifying your investments, you can work with Vincere to build a portfolio composed of assets that are attractive and suitable for your needs. If you're interested in an investment advisory or financial planning relationship, please consider Vincere Wealth Management.

Schedule a FREE 1:1 session here to connect with a #VincereWealth Advisor.

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