Interest is one of those financial terms you hear all the time on loans, credit cards, savings accounts but it can feel confusing if you’re new to money topics. Don’t worry. Once you understand the basics, interest is actually pretty straightforward.
At its core, interest is the cost of using someone else’s money or the reward for letting someone use yours.
Interest Explained in Plain English
When you borrow money, interest is what you pay extra on top of the amount you borrowed. When you save or lend money, interest is what you earn.
Think of it like renting money:
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Borrower → pays rent (interest)
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Lender → collects rent (interest)
Banks, credit card companies, and investors all use interest as a way to make money.
How Interest Works in Real Life
Interest is usually shown as a percentage, often called an interest rate. That rate is typically listed on a yearly basis.
Example: Borrowing Money
Let’s say you borrow $10,000 to buy a car at a 6% interest rate.
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Amount borrowed (principal): $10,000
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Interest for one year: $600
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Total to repay: $10,600
That extra $600 is the cost of borrowing the money.
Example: Saving Money
Now flip the situation. You deposit $10,000 into a savings account that pays 6% interest.
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Your original money stays intact
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You earn $600 in interest over a year
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Ending balance: $10,600
Same numbers totally different outcome. Whether interest helps or hurts you depends on which side of the deal you’re on.
Why Lenders Charge Interest
Lenders don’t just charge interest for fun. Interest compensates them for:
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Risk (you might not repay)
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Time (they can’t use the money elsewhere)
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Inflation (money loses value over time)
Generally speaking:
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The riskier the borrower → the higher the interest rate
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The longer the loan → the more interest paid
That’s why credit cards usually have much higher interest rates than mortgages.
How Interest Works When You Borrow
Installment Loans
These include mortgages, auto loans, and student loans. You make fixed payments over a set period.
Each payment includes:
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Some money paying down the loan balance
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Some money covering interest
At the beginning, a larger share goes toward interest. Over time, more goes toward the principal.
Revolving Credit
Credit cards are the most common example. You can borrow, repay, and borrow again up to a limit.
Interest is charged on whatever balance you carry from month to month. If you pay your balance in full every month, you usually avoid interest entirely.
Do You Always See Interest Listed Separately?
Not always.
With many loans, interest is built into your payment. You don’t get a separate bill labeled “interest,” but you’re still paying it.
That’s why it’s important to read your loan agreement carefully.
Interest Rate vs. APR: What’s the Difference?
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Interest rate: The cost of borrowing the money itself
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APR (Annual Percentage Rate): The interest rate plus certain fees and extra costs
APR gives a more complete picture of what a loan really costs, which makes it useful when comparing offers from different lenders.
How You Earn Interest
You earn interest by letting others use your money. Common ways include:
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Savings accounts
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Certificates of deposit (CDs)
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Bonds
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Money market accounts
When you deposit money in a bank, the bank lends it out to others. In return, it pays you a portion of what it earns.
The Power of Compound Interest
Compound interest is where things get exciting especially for savers.
Compound interest means you earn interest on both your original money and the interest you’ve already earned.
Simple Example
You deposit $1,000 at 5% interest:
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After one year with simple interest → $1,050
But most banks compound interest daily.
With daily compounding:
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Balance after one year → $1,051.27
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You earn interest on your interest
That extra dollar or two might not seem like much, but over many years and with larger balances it adds up fast. This is why starting to save early matters so much.
Why Savings Accounts Pay Lower Interest
Savings accounts are very safe. In the U.S., they’re federally insured, and you can usually withdraw your money anytime.
Low risk + high flexibility = lower interest rates.
Higher-return options usually come with more risk or less access to your money.
Common Questions About Interest
Who pays interest on a loan?
The borrower does. If a lender offers a 0% interest promotion, the borrower avoids interest but those deals often have conditions.
Why do higher interest rates slow inflation?
When interest rates rise:
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Loans become more expensive
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People and businesses borrow less
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Spending slows down
With lower demand, prices stop rising as quickly, which helps control inflation.
