What is Interest?

By itself, interest is a pretty basic concept: it’s money you pay as a fee for using someone else’s money, basically a charge on a service. We’re used to that in our daily lives, from bank fees to online transaction fees to any other number of small charges for the privilege of using a service or a platform.

At its core, it’s figured like this: if you borrow $2,000 and have a (high) interest rate of 25%, you’ll owe $500 for that $2,000. Though you borrowed $2,000, you’ll owe $2,500 at the end of the period. The $500 is the fee the lender collects as payment for lending you the money in the first place.

That all makes sense so far. But it gets more complicated in many instances - a lot more complicated.

Annual percentage rate, or APR, is the amount of interest that is compounded per year. It’s often used interchangeably with interest, but APR can also include other fees associated with the loans depending on the lender. Credit cards charge interest rates ranging from competitive to very high; some lines of credit have very onerous interest payment rates and terms, so it’s important to be aware of how APR and interest works on personal payment systems as well. 

Interest rates are typically determined by calculations using the Federal Funds Rate and the Prime Rate. Federal Funds Rate is the rate banks use to lend to one another, and the prime rate is the rate a bank would use to lend to an ideal customer with good credit. Factoring these two values helps inform a realistic and plausible interest rate.

Interest rate calculations and their payment schedules become far more complicated depending on numerous factors ranging from financial and credit status to lender type to institution and market value. Student loans and business loans can have different interest rates and payment plans, for instance, though they are similar in design, i.e. a lender is lending you money for your own personal use with the promise of repayment and personal profit on the part of the lender. This is why interest rates can be compared with different types of loans and different financial sectors, but there is a very strong variance in use and type and terms that a borrower will need to understand.

How Interest Can Work for You

Interest can also be beneficially compounded and make you a profit.

For instance, if you have an interest-bearing savings account at a bank with $1,000 and a 1% compounded APY (annual percentage yield), after two years you’d had more than $10 added to your total. Banks give interest as a payment for lending out your money as investments or loans to other customers and companies. Much like how interest is charged to you for the privilege of borrowing money, banks pay you for the privilege of borrowing and using your money.

Savings accounts and interest-bearing accounts are by the far the best way to make money with interest, though it can take a lot of time to earn noticeable profit from such investments.

Why Paying on Time is Important

Credit cards are a convenient way to make purchases while building your credit history and score - but it comes with a catch. Whereas a debit card, cash, or checks are direct payments taken from your checking account, a credit card allows you to pay based on your credit and then make payments later with interest. For some cards, this can be a huge snag.

For instance, if you have a credit card with an APR of 27%, you’ll be making huge payments on your credit card debt. The interest alone can seriously delay your financial freedom by extending the repayment horizon and adding costs to money you’ve already spent. While credit cards are the most well-known for this issue (as it has created unbelievable amounts of debt), high interest rates and extended repayment terms have been a focal point for personal finance for years because there is such a wide variance of loan types and terms.

We’re hearing a lot more about student loans and debt forgiveness in the news these days. Collectively, students in the United States owe trillions of dollars for educational debt, including the interest rates which continuously accrue each year and make the debt even greater, and the resulting payoff time that much further off. A student taking out a college loan for a set amount can find they have to pay 7%, 10%, or even 20% (and sometimes higher) interest rates on the principal; this can seriously delay their financial freedom, with many saying they won’t be paid off until decades in the future.

One mechanism to reduce college debt that has been proposed is to freeze or cancel the interest rates on these loans while keeping everything else active. This would naturally make the payments lower and save students money, but it puts the lending institutions at risk by reducing their financial incentive to lend out to students and other possible consumers who risk non-payment or partial government forgiveness.

This is an example of why interest is such a big issue in the United States today. Between credit cards, loans, and bills, interest rates can heighten debt totals and make your repayments much higher. A good strategy to avoid interest charges is to pay on time, in full, and pay off cards or loans with the highest APR first. This sort of smart budgeting and financial planning can save you incredible amounts of money that you don’t need to spend.

When taking out loans or credit cards, pay close attention to their APR and repayment terms; don’t be suckered by upfront benefits or perks that are used to disguise bad terms on the repayment backend. If you’re able, make bigger payments on your loans or cards than is necessary to increase the rate of payoff and beat the yearly accruing interest rates that will kneecap your expenses for possibly decades to come.

There are many smart budgeting items to consider when making this work, but if one wants to beat interest payments it’s necessary to make wise financial decisions and take APR into account at all times. Budgeting and personal finance can be tough for young people especially to take up and learn, but the more this is learned at a younger age the better your chances of understanding how the financial world works and the more likely you are to avoid onerous financial terms that won’t work for you.

It isn’t necessary to understand the full mathematical ins and outs of interest across all accounts, loans, and payment systems to know the basics that can help ensure your financial freedom that is achievable on your schedule.