What is it for and why? I found a lot of questions on interest rate but not what interest itself is
Thanks in advance 🙂
Edit: Thank you for all the replies i am now a financial god of wisdom, i’m not going to reply to unless something is unclear to me but comments will all be read
In: 9
If you need money, then you need to convince me to give it to you. One way is by promising to pay me back plus an additional amount. That additional amount is the lender’s “interest” in the loan.
If I don’t know or care about you then the only reason for me to give you money is if I develop an interest in the loan.
Interest exists because not all money is equal.
Money today is worth more than money tomorrow .. why? Inflation. This is more relevant now especially as covid has forced our government to print print and print more money for subsidies.
Give me $100 of your money today.
I’ll give you back $120 of 2023 dollars.
The person giving the loan is expecting that 20% return will outpace 3% inflation and poof you have profit.
Suppose you borrow 100$ from someone. Now, the person giving you the 100$ could do so “without interest”, meaning that you only have to pay back those exact 100$ – regardless of when you do so.
If the person demands interest, they’re saying: I’ll lend you 100 bucks, but for every month you haven’t paid me back those 100 bucks, you’ll have to pay me a little bit extra atop of that.
Interest is usually based on percentages. So if that guy wanted 1% interest on his 100 bucks, you’d then have to pay back the 100 bucks PLUS one additional buck (100 * 1%). And if you hadn’t paid him back after two months, it would be (101*1%)=102,01$, and so forth.
The idea basically is to a) make you pay back your loan in a timely fashion because the longer you don’t pay, the more you’ll have to pay. And b) The person you borrowed money from gets “paid” for borrowing you money via the accumulating interest.
Mind you, this can also go the other way when *you* deposit money with a bank. The bank will then pay interest to you because it doesn’t just safeguard the money for you (in most cases), but actively uses it to finance other parts of its business.
Interest is, simply, the price you pay to someone else for them lending you money. (Or in reverse, the amount you charge someone else for lending them money. Same thing, opposite POV.)
A simple example: “I will lend you $100. For every day until you pay me back, the amount you have to pay me back goes up 1%.”
The initial amount, the $100, is the PRINCIPLE.
After the first day, it would go up to $101. Then that amount increases by 1%, so $102.01. Then the next day, $103.03, and so on.
In real life: When you use a credit card, a bank is lending you the amount of money you need to make that purchase, and charges you interest on that amount until you pay it back. It tracks each individual purchase to ensure that interest is being charged correctly.
On the flip side, when you deposit money with a bank, you are effectively lending them YOUR money. They will pay you interest on your deposits (or else they used to. It’s rare anymore, and if they do, it’s a paltry amount.)
Most of the time you will hear the term APR, or Annual Percentage Rate, which is the interest rate for an entire year, but different types of loan may calculate interest daily, weekly, monthly, or yearly, even if they TELL you the rate over the course of a year, there is math underneath happening.
Money loses value with time. 10 000$ today could be worth 9 000$ in 10 years (it’ll still be 10 000$ but what you can buy with it would be worth 9 000$ today). So since money loses value, you have to add an amount to a loan to compensate for it so that the lender doesn’t lose money or even earn money lending it to you.
Interest rate is that amount needed so that the lender won’t lose money / earn some.
Bobby: Hey Sue, lend me $100. I promise I’ll pay you back!
Sue: No way, man.
Bobby: If you lend me $100, I’ll wash your car!
Sue: No way, man. I just washed my car.
Bobby: If you lend me $100, I’ll … make you dinner for a week!
Sue: No way, man. All you know how to make is toast.
Bobby: Come on! There has to be something I can offer you that will make you lend me the money. Oh I know! If you lend me $100, I’ll repay you $125, how about that?
Sue: Well, that sounds like a good deal!
The extra $25 is interest.
When someone lends money to someone else, there’s always a risk that they won’t repay the loan, for various reasons. People can get sick and die, a venture might go bankrupt etc. So if I lend you money then I need to see some sort of incentive to counter that risk. That incentive is interest. If there was no interest, then overall I’d be losing money in lending due to people not repaying from time to time.
It’s the cost of borrowing money. Would you lend out your money if you were going to get nothing in return? Especially since there’s a chance they won’t pay it back. You’re taking risk but getting no reward.
Because if i lend you 100$ and expect you to pay me back in a week, i have 100$ less until you repay me.
So i need a reason to give you 100$. If you’re not a friend, that reason can be getting 110$ back. That’s interest.
Lots of good replies here but the one thing that seems to be missing is the fact that the money needed to pay the interest does not actually exist. It is tacked on to the principal which is the only money loaned out. How do you get the money needed to pay the interest? It’s a mathematical impossibility that keeps all of us in perpetual financial chains.
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