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How Interest Works

How Interest Works

How Interest Works

Interest is not that interesting for many people, but it is absolutely essential to understand if you want to be an investor and learn to be good with money. Interest is the simple concept that borrowing money costs money. If a bank or other lending institution is going to lend you money, they need to be getting something for it, which they do by way of interest payments.

Not only is interest a fundamental concept to understanding loans, but it also makes a real, tangible difference on the amount of money you end up having to pay back—they affect your wallet! Let’s look at how interest rates work, types of loans, and how to keep as much of your hard-earned money in your wallet as possible to start.

How Do Interest Rates and Payments Work for Loans?

When a bank or other lending institution loans you money, especially when it is a large sum for a house, they are taking on a level of risk. They can vet the borrower as much as possible, but there is still risk to them that the person may default on their payments. Therefore, the lender charges interest on top of the original loan.

Another way of looking at interest is that it is the cost of borrowing money. It’s like that old adage, “nothing in life is free,” and neither is borrowing!

Interest rates can be fixed (stay the same for a length of time) or variable (fluctuate periodically). Interest rates change over the years, and are currently fairly low, though not the lowest they have ever been. The state of the economy will push rates up and down, so you’ll want to understand how that can impact the timing of your borrowing and duration.

Interest rates are calculated based on the principal loan amount. Say you borrowed $100,000 at a 3% interest rate, then you will actually end up paying back $103,000 back to the lender. This amount is typically broken down into monthly payments so you are not paying it all back at once.

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Why Low Interest Rates Matter

As illustrated, the interest rate directly affects the amount of money you will end up paying back to the lender. That’s why low interest rates are so desirable—they will ultimately make you pay back much less than if it was a high interest rate.

Using the same example as before, say someone borrowed $100,000 at a 5% interest rate—they would ultimately pay back $105,000, which is a full $2,000 more than the 3% rate. Now, imagine if you were borrowing even more than that $100,000 for a larger home or land purchase—interest starts to add up really quickly when the loans are larger! There are many offers from lenders that have high interest rates and unique percentages that can impact your money daily.

Credit cards provide higher percentages, and the statements show the rate(s), minimum amount for payments on the amount of money used and how long it will take you to pay off over a period of time. Understanding how money and interest rates affect your finances are incredibly valuable.

Types of Loans: Traditional, Hard Money, Crowdfunding

When considering taking out a loan, there are a few different ways to go and they have different implications for interest rates. Here are the three main types of loans:

  • Traditional loan: This is what was described earlier, when a borrower gets a loan from a bank or another financial institution and agrees to the interest terms. They then make monthly installment payments until they have repaid the initial principal and interest.
  • Hard money loan: This refers to a loan, typically in real estate, when the borrower gets a loan from a company or individual instead of a financial institution. Interest rates tend to be higher than traditional loans because there is not the same formal vetting process and regulatory measures in place for the lender. The asset becomes more important than the individual in most cases when this type of funding is used.
  • Crowdfunding: This is a more recent kind of loan and is also referred to as “social lending,” where multiple individuals loan small amounts to the borrower. This is done on a much smaller scale and relies on trust between individuals. Interest rates and other aspects are not regulated like traditional loans. Depending on the need and risk tolerance you might look to other ways of money.

It’s important to consider the different kinds of loans and see what will work best for you. Then, talk to different institutions to see who can offer the best interest rates on your loan to ensure that you are not spending more money than you need to. Interest rates are very important to understand and securing a low interest rate will make you happy that you took the time to learn about them. Also, make sure you learn more about credit scores both personal and business related.

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Big picture takeaway points

  1. Lenders take on a level of risk and therefore charge interest on a loan.
  2. Interest is the cost of borrowing money.
  3. There are different types of loans and therefore different interest rates.


Self-reflection questions to think more about the content

  1. How could an interest rate affect my finances?
  2. What type of loan would I prefer and would I qualify?
  3. Am I familiar with the types of loans offered by my current lending institution?

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