# Interest: Definition and Types of Fees for Borrowing Money

> **Definition**
>
> Interest is a charge for borrowing money, typically expressed as a percentage of the principal amount borrowed. For lenders, it's the compensation for temporarily parting with their funds.

## What Is Interest?

Interest is the charge for borrowing money. Interest expense or revenue is often expressed as a dollar amount, while the interest rate used to calculate interest is typically described as an annual percentage rate (APR). It's also the amount of money a lender or financial institution receives for lending out money.

Interest can also refer to the amount of ownership a stockholder has in a company, usually expressed as a percentage.

### Key Takeaways

*   Interest is the monetary charge for borrowing money—generally expressed as a percentage, such as an annual percentage rate (APR).
*   Lenders may earn interest for using their funds or be paid by borrowers for using those funds.
*   Interest is often considered simple interest (based on the principal amount) or compound interest (based on principal and previously earned interest).
*   Interest is often associated with credit cards, mortgages, car loans, private loans, savings accounts, or penalty assessments.
*   Interest is highly dependent on macroeconomic policy dictated by the Federal Reserve's Federal funds rate.

![Interest](https://www.investopedia.com/thmb/DY_T0jX3-mroBigUhecxB304mFo=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/interest.asp-final-c3fdffd368294a708ea21ff11cd4df06.png)

*— Investopedia / NoNo Flores*

## Understanding Interest

Interest compensates one party for incurring risk and sacrificing the opportunity to use funds while penalizing another party for using someone else's funds. The person temporarily parting ways with their money is entitled to compensation, and the person temporarily using those funds is often required to pay this compensation.

When you leave money in your [savings account](https://www.investopedia.com/terms/s/savingsaccount.asp), your account earns interest. This is because the bank uses your money and loans it out to other clients, resulting in you earning interest revenue.

The amount of interest a person must pay is often tied to their creditworthiness, the length of the loan, or the nature of the loan. All else being equal, interest and interest rates are higher when there is greater risk; as the lender faces a greater risk of the borrower being unable to make their payments, the lender may charge more interest to incentivize them to make the loan.

> **Fast Fact**
>
> APR includes the loan's interest rate, as well as other charges, such as origination fees, closing costs, or discount points.

## History of Interest Rates

The concept of interest—the cost of borrowing money—is commonplace today. However, the acceptability of interest only began during the Renaissance.

Interest is an ancient practice, but social norms from ancient Mediterranean and Middle Eastern civilizations to Medieval Europe regarded charging interest on loans as a sin or usury. Before Christianity, the Greeks and Romans understood that making money off money itself was unnatural, as Aristotle argued in his _Politics_. Aristotle separated two kinds of moneymaking, which have been crucial for almost two millennia that followed him across Europe and the Middle East:

*   **Proper economic relations (_oikonomikē_)**: These belong to the needs of household management (English gets the word "economics" from the Greek term). Wealth is a means toward another end (food, shelter, property, the good life, etc.).
*   **Unnatural love of money (_chrēmatistikē_)**: Here, wealth acquisition becomes its own end through trade and using money to make more money. Aristotle viewed this form of moneymaking as unnatural and harmful to those who practiced it. In his _Nicomachean Ethics_, he suggested it was a life so foolhardy that it deserved no serious discussion when describing flourishing lives. He was particularly critical of usury (lending money at interest), which he saw as the most unnatural form of _chrēmatistikē_. Importantly, usury meant _any_ interest earned, not excessive interest, as is meant today.

Once these distinctions were carried through Islam and Catholic Scholasticism, usury was deemed a sin, unworthy of those who had their souls directed toward that which is eternal, not the money-grubbing and fallen nature of this world. Loans were just to make money on money. And if someone was in need, what kind of person would only give charity at a price? Lenders were seen as profiting from others' misfortunes.

The moral dubiousness of charging interest on loans began to fade during the Renaissance, first in Italy and then slowly as the seeds of later industrialization began to sprout. People started borrowing money to grow businesses and improve their economic standing. Growing markets and relative economic mobility made loans more common and charging interest more acceptable. During this time, money began to be considered a commodity, and the opportunity cost of lending it was seen as worth charging for.

Political philosophers in the 18th and 19th centuries, including Adam Smith, Frédéric Bastiat, and Carl Menger, elucidated the economic theory behind charging interest rates for lending money. They argued that interest was a legitimate compensation for the risk and opportunity cost associated with lending.

Islam still bans the charging of interest, known as _riba_ (رِبَا) in Arabic. Instead, Islamic banking practices often involve profit and loss-sharing arrangements. This approach to finance, which avoids traditional interest, is essential to understand for anyone involved in business and finance in the Islamic world.

Today, interest rates are applied to various financial products, including mortgages, credit cards, car loans, and personal loans. Central banks, like the U.S. Federal Reserve, use interest rates as a vital tool for monetary policy. Adjusting the [federal funds rate](https://www.investopedia.com/terms/f/federalfundsrate.asp) influences broader economic conditions.

Interest rates have seen significant fluctuations since around the beginning of the 2020s. Rates started to fall in 2019 and were brought to near zero in 2020 in response to the COVID-19 pandemic. However, the U.S. soon raised interest rates to combat inflation. This changed in 2024, as hiring slowed and inflation abated, resulting in the Fed cutting rates.

## Formula and Calculation of Interest

In its most basic form, interest is calculated by multiplying the outstanding principal by the interest rate.

**Interest = Interest Rate × Principal or Balance**

The more complex aspect of calculating interest is often determining the correct interest rate. The interest rate is often expressed as a percentage and is usually designated as the APR. However, [calculating the APR](https://www.investopedia.com/terms/y/yearly-rate-of-return-method.asp) often does not reflect any effects of [compounding](https://www.investopedia.com/terms/c/compounding.asp). Instead, the effective annual rate is used to express the actual rate of interest to be paid.

Often, an annual rate must be converted to calculate the applicable interest earned in a given period. For example, if a savings account is to pay 3% interest on the average balance, the account may earn 0.25% (3% / 12 months) each month.

The applicable interest rate is then multiplied by the outstanding amount of money related to the interest assessment. For loans, this is the outstanding principal balance. For savings, this is often the average balance of savings for a given period.

In either case, the amount of interest assessed each period will likely change. For loans, borrowers will have likely made payments that reduce the principal balance, resulting in lower interest. For savers, general activity (including the addition of last month's interest) often changes the applicable balance.

> **Important**
>
> Your credit score has the most impact on the interest rate you are offered when it comes to various loans and lines of credit.

## Simple Interest vs. Compound Interest

Two main types of interest can be applied to loans: [simple](https://www.investopedia.com/terms/s/simple_interest.asp) and [compound](https://www.investopedia.com/terms/c/compoundinterest.asp). Simple interest is a set rate on the principal originally lent to the borrower that the borrower has to pay for the ability to use the money. Compound interest is interest on both the principal and the compounding interest paid on that loan. The latter of the two types of interest is the most common.

For obvious reasons, individuals attempting to earn interest prefer compound interest agreements. This agreement results in interest being earned on interest and results in more total earnings. Savings accounts with banks often earn compound interest; any prior interest earned on your savings is deposited into your account, and this new balance is what earns interest in future periods.

Meanwhile, compound interest is extremely concerning for borrowers, especially if their accrued compound interest is [capitalized](https://www.investopedia.com/ask/answers/040915/what-does-it-mean-capitalize-accrued-interest.asp) into their outstanding principal. This means the borrower's monthly payment will actually increase because of having a greater loan than what they started with.

## Common Uses of Interest

There are countless ways a person can charge or be charged interest. Below are some common examples of where interest may be earned by one party and paid by another.

*   **Credit cards**: Among the methods of borrowing money that incur the highest amount of interest, [credit cards](https://www.investopedia.com/credit-card-4689721) are known for having a high APR. Consumers may make minimum monthly installment payments; in return, interest expense may accumulate and is earned by the credit card providers/underlying financial institutions.
*   **Mortgages**: Among the longest-term loans, mortgages often incur interest over the entirety of their potential 30-year term. Though interest may be assessed as a fixed or variable rate, it is theoretically reduced over time as the borrower pays down the original loan principal amount.
*   **Auto loans**: An example of a shorter-term loan, auto loans are often awarded for terms up to six years. Interest is often charged as a fixed rate, and the dealership extending credit may have an in-house financing department that collects the interest revenue.
*   **Student loans**: During COVID-19, [student loan](https://www.investopedia.com/student-loans-4689727) payments were paused, and prevailing loan rates were dropped to 0%. This meant that for a while, all loans incurred no interest assessments.
*   **Savings accounts**: Often a positive type of interest for most consumers, savings accounts earn monthly interest assessments. Also called dividends, these deposits are automatically credited to your account.
*   **Invoices**: Though many companies may assess a late fee, some companies choose to assess an interest charge on outstanding and late invoices. The idea is that since the late payer is technically borrowing money from the invoice holder, the invoice holder is due interest.

> **Tip**
>
> A quick way to get a rough understanding of how long it will take for an interest-bearing account to double is to use the so-called rule of 72. Simply divide the number 72 by the applicable interest rate. At 4% interest, for instance, and you’ll double your investment in around 18 years (i.e., 72/4).

## Advantages and Disadvantages of Paying Interest

Imagine a situation where you need reliable transportation to get to work. There is no public transit system, you do not own a car, work is far away, and you can't afford to buy an entire car outright. The largest advantage of paying interest is its relatively low expense compared with alternatives.

Paying interest also means a payer is holding debt, building their credit history, and potentially effectively using [leverage](https://www.investopedia.com/terms/l/leverage.asp). For example, real estate developers often borrow money to construct and rent buildings. If the rate of return on the building is greater than the interest rate they are charged, the company is successfully using someone else's money to make money for themselves.

On the downside, interest is a recurring cash expense. Payers are often contractually obligated to pay interest, and monthly payments are typically applied to interest assessments before paying down the principal. Consumers may find interest assessments overwhelming. In addition, having too many loans and monthly payments that are too high may restrict a borrower from being able to take out more credit.

### Interest for Borrowers

Pros

*   May be the result of much-needed capital; relatively speaking, it may be worth the small expense during emergencies.
    
*   Is a result of building a strong credit history
    
*   May be used to leverage returns and generate higher profits
    

Cons

*   Is a real expense requiring cash outlay
    
*   Is usually paid before any principal balance can be paid down
    
*   May compound and become overwhelming for a borrower to overcome
    
*   Are contractually obligated to be paid
    

## Advantages and Disadvantages of Collecting Interest

A strategy for many investors is to collect interest. Often, a fixed amount, interest provides positive cash flow that is a reliable source of income, depending on the creditworthiness of the person borrowing the money. Instead of having capital sitting around and not being used, lending money to others is a more efficient way of deploying capital, especially in the short term when the lender may need that money for a specific reason in the longer term.

Interest is also touted as one of the simplest forms of [passive income](https://www.investopedia.com/terms/p/passiveincome.asp). Loans may require little to no administration or maintenance after signing the agreement. Lenders may simply collect interest and principal payments.

There are some downsides to collecting interest. First, [interest revenue is taxable](https://www.investopedia.com/high-yield-interest-impact-on-taxes-8414834); even a tiny amount may push a taxpayer into a higher tax bracket. Next, because you are collecting interest, this means you are allowing someone else to use your capital. Though you may be satisfied collecting interest, there will often be greater earning potential had you utilized the capital yourself.

Also, collecting interest may have philosophical opponents. Consider student loan debt assessments. While some say interest rates near 10% are reasonable for the amount of risk these lenders are incurring, others claim these rates are predatory to young adults and should not be assessed.

### Interest for Lenders

Pros

*   May provide source of cash flow if interest payments are collected monthly/frequently
    
*   May be a passive source of income
    
*   May provide a consistent stream of income if the borrower is reliable in their payments
    
*   Is a more efficient use of capital instead of not lending it out
    

Cons

*   Will increase a taxpayers tax liability
    
*   May be lower than what could have been earned had the lender deployed capital for their own investment purpose
    
*   May attract negative attention in some situations depending on the borrower, rate of interest, and circumstance
    

## Interest and Macroeconomics

A low-interest-rate environment is intended to stimulate economic growth so that it is cheaper to borrow money. This is beneficial for those who are shopping for new homes simply because it lowers their monthly payment and means more affordable costs. When the [Federal Reserve](https://www.investopedia.com/terms/f/federalreservebank.asp) lowers rates, it means more money in consumers' pockets [to spend in other areas](https://www.investopedia.com/ask/answers/071715/how-do-changes-interest-rates-affect-spending-habits-economy.asp) and more large purchases of items, such as houses. Banks also benefit from this environment because they can lend more money.

However, low interest rates aren't always ideal. A high interest rate typically tells us that the economy is strong and doing well. In a low-interest-rate environment, there are lower returns on investments and in savings accounts, and, of course, an increase in debt, which could mean a higher chance of default when rates go back up.

In response to COVID-19, the Federal Reserve began enacting monetary policy as early as March 2020. Then, as the pandemic eased, the Federal Reserve began raising the federal funds rate. As this federal funds rate influences the interest rate on many other types of loans, borrowers soon found it to be more expensive to incur debt. In September 2024, the Fed began cutting rates after seeing inflation ease and hiring slow. These rate cuts apply to borrowing on everything from mortgages to cars to credit cards.

## What Is Accrued Interest?

Accrued interest is interest that has been incurred but not paid. For a borrower, this is interest due for payment, but cash has not been remitted to the lender. For a lender, this is interest that has been earned that they have not yet been paid for. Interest is often accrued as part of a company's financial statements.

## What Is the Best Way to Earn Interest?

Investors can deposit funds into alternative investments that generate interest in many ways. This also means investors must be careful when selecting borrowers. The best way to earn interest is to research the risk profile of your borrower; should they default on the loan, you may not have recourse to recover your lost principal.

## How Much Interest Do Bank Accounts Pay?

The amount of interest paid by bank accounts will vary widely based on prevailing government rates and macroeconomic conditions. For example, during the COVID-19 pandemic, while the federal funds rate was low, interest rates on bank accounts were near 0%. Then, as the pandemic eased, bank accounts began paying higher interest rates as the Fed tried to ease inflation by increasing the fed funds rate.

## The Bottom Line

Interest is critical for capitalist economies. By allowing individuals to borrow and lend money, society has greater economic prosperity by encouraging spending. As a result, capital likely doesn't sit around idly; it is borrowed by some and lent by others. Through the payment of interest, individuals are encouraged to always put money to use.

> **Article Sources**
>
> 1.  Aristotle. "[Nicomachean Ethics](https://historyofeconomicthought.mcmaster.ca/aristotle/Ethics.pdf)," Book I, chapter IV. Kitchener Press, 1999.
>     
> 2.  Aristotle. "[Politics](https://classics.mit.edu/Aristotle/politics.html)." Pages 1257a-1259e. Clarendon Press, 1905.
>     
> 3.  Islamic Finance Foundation. "[The Establishment of National Interest Free Banking Systems in Iran, Sudan and Pakistan](https://www.islamicfinance.com/2015/02/establishment-national-interest-free-banking-systems-iran-sudan-pakistan/)."
>     
> 4.  U.S. Federal Reserve. "[Federal Reserve Issues FOMC Statement](https://www.federalreserve.gov/newsevents/pressreleases/monetary20240918a.htm)."
>     
> 5.  Federal Student Aid. "[COVID-19 Loan Payment Pause and 0% Interest](https://studentaid.gov/announcements-events/covid-19/payment-pause-zero-interest)."
>     
> 6.  Board of Governors of the Federal Reserve. "[Federal Reserve Actions to Support the Flow of Credit to Households and Businesses](https://www.federalreserve.gov/newsevents/pressreleases/monetary20200315b.htm)."
>     
> 7.  Board of Governors of the Federal Reserve System. "[Federal Reserve Issues FOMC Statement](https://www.federalreserve.gov/newsevents/pressreleases/monetary20220504a.htm)."