# How does interest work?

## 04/24/2022

Interest is compensation for borrowing money. Whether it’s you lending to others or others lending to you, the lender requires a percentage of additional money paid. If the money were not being loaned out, the lender could use it for other purposes. But because it is, they require additional money. In other words, it’s the price of borrowing money. Additionally, interest could be in the sense of investing. If you put money into the bank, they’ll likely give you an additional percentage of money as interest; for banking with them.

Typical Interest rates are controlled by the individual bank and the bank policies are controlled by the “Fed” or federal reserve system.

** Simple Interest**

There’s two types of interest you may come across. Simple interest is based on the amount of the original loan or deposit. It’s the same every time. As you can imagine, simple interest would be more advantageous for the borrower. For example, if you invested $200 with a 3% interest rate over the course of 2 years, the first year, you’d get an additional $6; annual interest, calculated by multiplying the principal amount by the percentage, in this case 200 times .03. The second year, you’d get another $6, still calculated off the principal amount. Bringing you to a total of $12 interest.

**Compound interest**

The second type of interest is compound interest. Compound interest is calculated on both the principal amount and the accumulated interest, so it grows every time. An example of this would be, again, if you invested $200 with a 3% interest rate over the course of 2 years, the first year, you’d get an additional $6; annual interest, calculated by multiplying the principal amount by the percentage, in this case, 200 times .03. But the second year, you’d do 206 times .03, giving you $6.18, bringing you to a total of $12.18 interest.

** Loans**

There are lots of reasons you might take out a loan and there are lots of places you might take a loan from as well.

Personal loans would be for anything personal, large purchases, things like funeral expenses, home renovations, or consolidating debt.

Auto loans would be for purchasing a car.

Student loans are to pay for tuition or needed supplies, like textbooks or room and board.

Mortgage loans are for purchasing or refinancing property, like a house. Mortgage loan interest rates should not be confused with APR or annual percentage rate, which is the interest rate plus a variety of other fees and charges relating to real estate.

Home equity loans are loans that allow you to take out the amount of money secured by your property.

Credit builder loans are to improve your credit score.

You might get a loan from a bank, credit union, or online fast money lender.