What Is Interest?

Interest is the monetary charge for the privilege of borrowing money, 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.

Key Takeaways

  • Interest is the monetary charge for borrowing money—generally expressed as a percentage, such as an annual percentage rate (APR).
  • Key factors affecting interest rates include inflation rate, length of time the money is borrowed, liquidity, and risk of default.
  • Interest can also express ownership in a company.
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Interest

Understanding Interest

Two main types of interest can be applied to loans—simple and compound. Simple interest is a set rate on the principle 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 principle and the compounding interest paid on that loan. The latter of the two types of interest is the most common.

Some of the considerations that go into calculating the type of interest and the amount a lender will charge a borrower include:

  • Opportunity cost or the cost of the inability of the lender to use the money they’re lending out
  • Amount of expected inflation
  • The risk that the lender is unable to pay the loan back because of default
  • Length of time that the money is being lent
  • Possibility of government intervention on interest rates
  • Liquidity of the loan

A quick way to get a rough understanding of how long it will take for an investment to double is to use the rule of 72. Divide the number 72 by the interest rate, 72/4 for instance, and you’ll double your investment in 18 years.

APR includes the loan's interest rate, as well as other charges, such as origination fees, closing costs, or discount points.

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.

Special Considerations

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 in 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.

Types of Interest Rates

There are a variety of interest rates, which include rates for auto loans and credit cards. As of November 2020, the average auto rate for a five-year loan for a new car was 4.22%. Meanwhile, for 30-year mortgages, the average fixed rate was 3.22%.

The average credit card interest rates vary according to many factors such as the type of credit card (travel rewards, cashback or business, etc.) as well as credit score. On average, the interest rate for credit cards as of November 2020 was 16.03%.

Your credit score has the most impact on the interest rate you are offered when it comes to various loans and lines of credit.

The subprime market of credit cards, which is designed for those with poor credit, typically carries interest rates as high as 25%. Credit cards in this area also carry more fees along with the higher interest rates and are used to build or repair bad or no credit.