What is interest?
Firstly, interest is the amount of money a lender or financial institution (most commonly a bank) charges for lending people money through loans. It is usually expressed as a percentage of the amount loaned to an individual over a period of time and is the main way in which financial institutions accrue money from borrowers.
So let’s say you take out a loan of $600,000 to purchase your first home, and your bank has an annual fixed interest rate of 4%. Your bank will then receive $240,000 in interest on top of the principal amount. This is for traders who are borrowing and lending money: it means there’s interest to be made when investing your money!
Secondly, interest refers to the amount of shares an investor holds within a particular company, and which is also expressed as a percentage. We’ve talked before about how when you buy a stock, you own a percentage of the company. So if you purchase one stock from a company which holds 1,000 stocks, you own 0.1% of the company. This percentage is also referred to as interest.
KEY TAKEAWAYS
- Interest is the amount of money a lender or financial institution charges for lending people money through loans
- It's expressed as a percentage of the amount loaned to an individual over a period of time
- It also refers to the amount of shares an investor holds within a particular company, and which is also expressed as a percentage
- There are 2 main types of interest to know about: Simple and compounding
2 types of interest
There are two types of interest that are applied to loans: simple interest and compound interest.
What is simple interest?
Simple interest is a set rate charged on the initial amount of money borrowed. So if you borrow $10,000 to buy a new car and the bank charges a 4% simple interest rate, you’ll pay a fixed interest rate of $400 on top of the principle $10,000 – so $10,400 in total.
What is compound interest?
Compound interest is interest on both the principal and the accumulating interest paid on that loan. Compound interest is great when it comes to investing, as it allows your money to grow over a long period of time.
If you invest $1,000 tomorrow, then $1,000 in a year, and you continue doing that for 30 years with an interest rate of 8%, in 30 years time you could have a pot of $113,283. That’s $83,283 earned in interest!
Compound interest is one way to beat inflation.
Difference between simple and compound interest
In a nutshell, the difference between simple interest and compound interest is that when calculating simple interest, you don't add the interest of previous years into the calculation of the new interest amount.