Interest is a word that you have probably heard a lot when it comes to paying off debt or investing. It certainly is an important factor and it’s useful to know exactly how interest works in all the different situations. Whether you are investing your money and hoping to earn interest or trying to pay off debt and looking to pay less interest, here is what you need to know.
What is interest in debt repayment?
When it comes to debt repayment, interest is the amount of money you need to pay monthly at a particular rate for the use of the money you borrow or for delaying the repayment of the debt. To put it simply, interest is the cost of borrowing money.
Whenever you make a loan you will accept to pay it back at a certain interest rate expressed in percentage. The interest rate you will need to pay depends on the institution that lends you money as well as your credit history which determines your credit score. Generally, the higher your credit score, the more chances you have to lock in a lower interest rate.
How can you earn money from interest?
You can also earn money from interest whenever you are the one lending money or when you open an interest-bearing bank account such as a savings account or a certificate of deposit.
When you deposit money in your savings account, the bank will periodically pay interest on your savings. The interest will be a percentage of the money you deposit. You can gain interest every month or quarterly, depending on the bank policy.
When it comes to the interest you earn in a savings account, you can either use it or leave it in the account to earn more interest. The second option is always recommended as you can then earn interest on your savings and your accumulated interest. This is known as compound interest.
What is compound interest?
Compound interest is the interest you earn on money that was earned as interest. Earning compound interest leads to an exponential growth of your account balance in the case of an interest-bearing account. You are basically reinvesting your interest to earn more money.
For example, if you earn 10% interest per year and you have 1000$ in your account, after one year you will have 1100$, your initial amount plus 100$ of interest. In the second year, you will earn a 10% interest on your balance of 1100$, meaning 110$, bringing your account to 1210$. In the third year, the interest will be 121$ and so on.
Compound interest is a simple way to grow your savings faster. Just pay attention to compound interest when you are repaying your loans as that will cause you to pay interest on top of the interest.