What Is Interest? (R) Rated

Well, when we’re talking about money and finance, interest is the price you pay to borrow money. On a side note, interest could also be the amount you make from lending somebody money as well but we’re going to focus on the cost side in this post. Interest is generally stated as an annual percentage rate, or APR.

Let’s look at an example. For ease of math, let’s say you borrow $100 from the bank. The bank then gives you 12 months to pay that $100 back WITH interest. Interest rates change (a lot of factors play into this like your credit score, prime rate, etc.) so you’ll want to pay attention to just how high that rate is because it directly translates to how much you have to pay back! For our example, we’ll put the annual rate at 10%.

The year flies by and you now owe the bank $100 plus interest. 10% interest on $100 is equal to $10 ($100 x .10). So, in total, you end up paying the bank back the original $100 borrowed and the $10 interest for a total of $110. Now, this is a very simplistic example. Many times, you pay back the $100 principle balance (more on principle in future posts) plus interest on a monthly basis.

I Do Not

want to confuse things in this post but what I do want to highlight is that while this is simple in concept, how it shows up can get a little complicated. If you want to learn more and just cannot wait for future Unmuddling Money posts, google TVM, effective vs. annual rates, and amortization schedules to continue down the rabbit hole.

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Let’s Relate

this to something near and dear to my heart – alcohol! On occasion, I end up going to my buddy’s house and consuming more beer than I brought with me. No, he typically doesn’t mind but I’m not going to end up being the mooch in our group of friends. So, if I go over to his house this weekend and plow through a few more cold ones that I brought with, the next time I end up at his house, I’ll bring twice as many as I drank the last time.

The little “extra” cost of me buying more beers than I can drink the second time I end up at my buddy’s house is a bit like interest. I replace, or pay back, what I consumed, or used, originally PLUS I end up leaving six extras behind. Replacing the original beers is like the principle in money terms and the extra six I leave behind for having the privilege of “borrowing” those beers the weekend before is like interest.

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In Many Ways

interest can be thought of as the cost of borrowing money. When it comes to mortgages, car loans, credit cards, and student loans, interest will be part of the equation. The higher the rate, the more whatever you just bought ends up actually costing you! Just keep in mind that interest rates will vary and the better you are at paying things off and managing money, the cheaper borrowing money can be (lower interest rates).

Oh, and while this post focuses on how interest costs you as a borrower, I’ll dig into compounding interest in a future post to show you how the right kind can be one of the strongest factors of building wealth!

Be sure to check out my additional posts on how to make more money!