What Is Interest? (E) 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 and they give 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 interest 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’re interested 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

the idea of interest to something most of us have done at some point – borrowing a car. When I was younger, I much preferred driving my parent’s Mustang GT. I loved the roar of the engine when I put my foot into the gas petal! Much to my dismay, my parents didn’t let me take the car out all that often. Typically, when they did agree to let me take the car, it came with a stipulation. I had to bring the car back with a full tank of gas.

Now, the tank wasn’t always full when I borrowed the car. So for me, I had to pay to replace the gas that I used PLUS I had to pay for the gas needed to bring the tank to full. Most of the time, I ended up paying for an extra quarter of a tank. This is very much like interest. The gas that I used was the original, or principle, amount borrowed. The extra gas I had to put in was the cost of me using the car – or the interest. Fortunately, we’re talking the days when gas was $.99 per gallon so I was only out a few extra dollars (percentage wise it was pretty expensive but that’s a topic for a different post).

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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!

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