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If you’re new to finance, hearing terms like interest, net worth, or liability might feel like encountering a “Welcome to the World of Finances!” billboard. Don’t worry, we’re here to break things down. In this guide, we’ll focus on a key concept: what is interest?
Understanding What is Interest and Its Terminology
In finance, the question of what is interest rarely stands alone. “Interest” is usually paired with another term that provides context, like interest income, interest rate, or interest expense. Understanding these terms will help you become a more informed financial planner.
What is Interest Income?
Interest income is the money earned from allowing someone else (like a bank or borrower) to use your funds. For individuals, interest income is what you earn on your bank or investment account balance. Think of it as a reward for letting your money work for you.
Interest Income Example: If you have $1,000 in a savings account with an annual interest rate of 2%, you’ll earn $20 in interest income over the year.
Simple Interest Income Formula: Interest Income = Account Balance × Interest Rate × Time.
However, most savings accounts use compound interest, meaning interest is calculated not only on the initial balance but also on the accumulated interest over time.
What is Interest Rate?
The interest rate is the percentage at which interest is calculated on an account balance. For deposit accounts and other expressions of interest income, this is often expressed as the Annual Percentage Yield (APY). For loans and other forms of credit, the interest rate and other costs of borrowing money are expressed as the Annual Percentage Rate (APR). APY accounts for the effects of compounding interest, whereas a simple interest rate does not. The APY on a savings account determines how much interest income you earn over time, making it essential to compare rates when choosing where to deposit your money.
Interest Rate Example: With a 2% APY, your balance will grow over time as interest compounds, leading to slightly higher earnings than a simple 2% calculation would suggest.
What is Interest Expense?
Interest expense is the cost of borrowing money. It typically applies to loans, credit cards, and other financial products where a lender charges interest on the amount borrowed. This is usually expressed as an Annual Percentage Rate (APR), which includes the interest rate plus certain fees.
Interest Expense Example: If you take out a $1,000 loan with a 5% APR, you will owe $50 in interest over a year, assuming no additional payments are made toward the principal.
What is Interest and How Does It Affect Your Bank Account?
Understanding how interest income, APY, and interest expense apply to a personal bank account can help you make better financial decisions and maximize your savings. Each component plays a unique role in determining what you can earn on your balance or what you might owe if you borrow funds.
- Interest income is what you earn on your balance, typically calculated using APY.
- Interest rate/APY determines how much interest income your money generates.
- Interest expense applies if you take out loans, use credit cards, or incur borrowing costs.
Making Interest Work for You
Everyone wants to earn money passively, and while there’s no magic formula, choosing the right financial tools can help. What is interest in the context of savings? It’s just one way to grow your money—many financial platforms also offer rewards, cashback, or bonuses to encourage saving and spending.
For example, some online finance platforms, like Remitly Circle, provide incentives such as deposit top-ups of up to 4% annually. While this isn't interest in the traditional sense, it can serve a similar function by boosting savings. (Note: Interest features may be introduced in the future.) When choosing where to store your money, consider both traditional interest-based growth and alternative incentives.
Key Takeaways: What is Interest?
When asking “What is interest?” remember that the answer depends on context. Interest can refer to:
- The cost of borrowing money (loan APRs, credit card interest rates, etc.).
- The earnings from savings and investments (APY on deposit accounts, interest on bonds, etc.).
Understanding how interest impacts both savings and borrowing can make you a more strategic saver and spender. Whether you’re earning interest income on your savings or managing interest expenses on a loan, staying informed about interest rates helps you make the most of your finances and achieve your financial goals.