What Is Interest?

Interest is the charge for the privilege of borrowing money, typically expressed as annual percentage rate (APR). Interest can also refer to the amount of ownership a stockholder has in a company, usually expressed as a percentage.



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
  • 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 being made

A quick way to get a rough understanding of how long it will take in order 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.

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. Some of those titles included the Theory of Fructification by Anne-Robert-Jacques Turgo, and Interest and Prices by Knut Wicksell.

Iran, Sudan and Pakistan removed interest from their banking and financial systems, making it so 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. In 2017, the Fed increased rates three times, due to low unemployment and growth in the GDP. Because of these numbers, interest rates are expected to continue to increase in 2018.

Different Interest Rates

By the end of 2017, you could expect the national average interest rate for an auto loan in the U.S. to be about 4.21% on a 60-month loan; for mortgages, the average 30-year mortgage interest rate was approximately 4.15%.

The average credit card interest rates vary according to many factors such as the type of credit card (travel rewards, cash back or business, etc.) as well as credit score. On average, the interest rates range from travel rewards cards being about 15.99%, business cards 15.37%, cash back cards 20.90% and student credit cards at 19.80% APR.

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.

Interest Rates and Credit Score

Your credit score has the most impact on the interest rate you are offered when it comes to various loans and lines of credit. For example, for personal loan APRs, in 2018, someone with an excellent score of 850 to 720 would pay approximately 10.3% to 12.5%. At the other end, if you have a poor credit score of 300 to 639, the APR will increase to 28.5% to 32.0%. If you have an average score of 640 to 679, your interest rate will be anywhere from 17.8% to 19.9%.

Low Interest Rate Environments

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.