Whether you’re borrowing money or saving it, interest rates play an important role in the financial world. Understanding exactly what they are and how they work can help you make the best decisions for your money.
A financial metric that represents the cost of debt for the borrower and the return on investment for the lender, interest is a percentage of the principal amount involved in a lending or savings transaction. Typically, it’s applied over a specific period, known as the loan or investment term. While it’s most commonly associated with loans, credit cards and other forms of credit, it can also be found in investments such as mutual funds.
In most cases, the interest rate charged on a loan or paid on an investment is calculated using one of two formulas: simple or compound. Compounding interest takes into account the principal balance and all accrued interest, which can result in larger totals. For example, a $100,000 mortgage borrowed at 5% for 10 years would accrue interest of $5,000. Simple interest, on the other hand, only takes into account the principal balance, resulting in a lower total.
While it’s generally unavoidable to pay interest when borrowing or investing, it’s always worth shopping around for the best rates. In addition to comparing quotes from lenders, it’s worth checking the comparison rate, which takes into account various fees such as annual loan fees, helping you see the true costs of a given loan.