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What is Interest and How Does it Work?

2021-12-21T16:52:37-06:00Personal Finance|

If you’ve taken out a loan, opened a credit card, or started a savings account, you’ve probably encountered the concept of interest. Because it’s such a common subject when it comes to our finances, it’s smart to understand what it is and how it affects you.

In the most basic terms, interest is the price paid for using someone else’s money. If you’re the borrower, you’ll pay interest. If you’re the lender, you’ll earn interest. It seems simple, right? Well, yes and no. It’s a bit more nuanced. Keep reading to get a better understanding of how interest works.

Paying Interest When You Take Out a Loan

When you borrow money from a credit union, bank, or another lender, you pay for the privilege in the form of interest charges. Think of it as a “convenience fee.” Each month, you pay back a portion of the money you borrowed plus an additional sum of money in the form of interest. This interest is calculated as a percentage of the loan’s balance and paid to the lender periodically. It’s usually quoted as an annual rate, but it can be calculated for any period.

Two common types of debt that typically include interest are installment debt and revolving debt. 

Installment debt includes vehicle loans, home loans, or student loans. Installment loans are paid off over a specific time period and have a fixed monthly payback schedule.

When you use an installment loan, interest costs are part of the monthly payment. Every month, part of your payment goes toward reducing your debt, while another portion goes toward the cost of interest. At the beginning of your loan, more of your monthly payment will go toward interest, even though the total amount you pay each month will remain the same. As the debt decreases, the interest owed will also decrease — and more money will go toward paying off the principal debt.

With revolving debt, you can borrow money each month and pay it back periodically. Credit cards are the most common form of revolving debt. When you use a credit card, you can keep spending money as long as you make monthly payments and stay beneath your credit limit. Credit card interest is calculated daily. As your balance climbs, so will your interest payment.

Earning Interest When You Open an Account

When you deposit money into an interest-bearing account or certificate, you are the one earning interest. This is because financial institutions use your deposited money to fund loans to other customers, and part of the money they make comes back to you as interest. When you look at your statements, you’ll see that your account balance increases periodically. You’ll also see an interest payment noted as a transaction. If you can leave the interest payment in the account, you’ll continue to earn more and more interest.

What’s more, some financial institutions offer compound interest (versus simple interest) on deposits. Simple interest is calculated on the initial amount of the deposit. Compound interest, on the other hand, is calculated on the initial deposit amount AND on the interest accumulated. In other words, compound interest essentially pays you interest on top of interest already earned.

One important note about earned interest that’s specific to credit unions: People that belong to a credit union are considered “member-owners,” so credit unions consider amounts paid on interest-bearing deposit accounts to be dividends. Because of this, any earned interest will be labeled as ‘dividends’ on statements or account transactions.

The Impact of Interest

As you can see, interest can have a big impact on the bottom line of a loan. As a borrower, the lower the rate, the better. But, when choosing a deposit product such as a Share Certificate or a Checking Account, the higher the interest the better.

As a member-owned financial cooperative, Connexus Credit Union gives back to members by offering low rates on loans and higher yields on deposits. That means when you choose Connexus over a big bank, you’ll pay less interest on your loans and earn more on your deposits. Win-win!

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