Takeaways
- Interest is the amount charged by lenders to borrow money and is expressed as a percentage.
- There are two main ways to calculate interest: simple or compound interest.
- The Federal Reserve sets the federal funds rate which broadly determines interest rates.
- Compounding interest is the more popular interest rate charged by lenders.
- Interest-bearing assets can supplement your portfolio and help you reach financial independence.
What Is Interest?
Interest is one of the fundamental concepts in finance, and it plays a critical role in lending and borrowing. In the simplest terms, interest is the cost of borrowing capital. When you borrow capital, you will typically pay interest. When you lend, you earn interest. Gaining a clearer understanding of the dynamics of interest is essential for making more informed, educated financial decisions.
Interest is a general term that represents the financial compensation an individual or entity receives for lending money.[1] Interest represents the cost of borrowing money and is typically expressed as a percentage. Interest rates are applied to the principal amount (sometimes plus accrued interest), which is the initial amount involved in the lending transaction.
Here is an example. If you lend a friend $100 with a 5% interest rate for one year, at the end of the lending period (or loan term), you will earn $5 in interest income and receive the $100 in principal. However, if you borrowed the $100, you would pay $5 and the $100 in principal.
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What Are Interest Rates?
Interest rates represent the cost of borrowing capital or the return on an investment represented as a percentage. Interest rates can be fixed or variable, which impacts the overall amount paid. When you borrow capital, the interest rate determines the additional amount you will need to repay beyond the initial amount borrowed, referred to as principal.
Multiple factors influence interest rates, including general economic conditions, inflation, and central bank policies. In more robust economies, the interest rates tend to be higher to help curb inflation. In more turbulent or corrective market conditions, interest rates are decreased to help stimulate spending and borrowing.
There are also different types of interest rates, including nominal, real, and effective rates. Nominal interest rates are typically the stated or advertised rates on loans or investments, while real rates are adjusted for inflation. Effective interest rates represent the real return when the compounding effect over time is considered.
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Who Sets Interest Rates?
In the United States, the U.S. Federal Reserve plays a central role in setting the general benchmark for interest rates charged by financial institutions. Interest rates set by the Federal Reserve are a reference point for lenders. The overnight federal funds rate set by the Federal Reserve is a barometer of market conditions and general economic health.
Banks and financial institutions use the overnight federal funds rate, set by the Federal Reserve, to create specific interest rates for mortgages, loans, and savings rates. The determination of these rates is a complex interplay of different factors and is not attributable to one single decision. In addition to these institutions dictating interest rates on various financial products, market forces fueled by supply and demand also contribute significantly to interest rates charged by other institutions.
Compound Interest vs. Simple Interest
Many people wonder what the difference is between simple interest and compound interest. The main difference lies in how interest is calculated. Each method has unique implications for lenders and borrowers.
- Simple Interest is calculated solely on the initial principal amount over a specified term and does not consider any interest earned or paid during previous periods (e.g., no compounding interest).
- Compound Interest, however, incorporates the interest accumulated from previous periods in its calculation. This compounding effect leads to exponential growth over time, making compounding interest more popular for lenders.
Compound interest is the standard for calculating interest on a wide range of financial instruments, such as checking and savings accounts, where interest income is earned not only on the principal but also on the interest accumulated during prior calculations.
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What Is Interest Income?
As a lender (anyone who gives someone else capital), you make interest income.[2] Generating interest income on your investments can increase your passive income streams and increase the chances of boosting your net worth.
Investing in assets that generate interest income – like bonds, certificates of deposit, savings accounts, and checking accounts – is crucial for diversifying your financial portfolio. Earnings generated from interest-bearing assets can fund your lifestyle or help you plan expenses.
Creating predictable interest income can be a vital part of your financial planning, particularly if you rely on income from retirement plans or are trying to achieve financial independence. Interest income helps add a layer of stability by creating predictable revenue or income, making investments and portfolios more resilient.
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Smart Summary
Whether you are trying to open a credit card, take out a car loan, or apply for your first mortgage, understanding how interest rates work is a smart money move. Interest expense can wreak havoc on your budget. On the other hand, interest income can be a nice supplemental income stream that helps you save more. Either way, having a firm grasp on how interest affects your portfolio is essential.
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(1) U.S. Securities and Exchange Commission. Interest. Last Accessed January 20, 2025.
(2) Internal Revenue Service. Interest Income. Last Accessed January 20, 2025.
