How Interest Works

Interest is what it costs to use money that belongs to someone else for a while. It is usually shown as a percent of the amount, charged or paid over a set period such as a year.

The starting amount of money is called the principal. Interest is figured as a percent of that principal. So a 5 percent rate on 100 dollars of principal is 5 dollars over a year.

When you put money in a savings account, you are lending it to the bank. In return, the bank pays you interest. Here you are the one earning, and a higher rate means more money paid to you.

Say you keep 500 dollars in an account paying 4 percent a year. After a year you would have about 520 dollars without lifting a finger. The 20 dollars is interest the bank paid you for keeping your money there.

When you borrow money, with a loan or a credit card, the lender charges you interest. Now you are the one paying. A higher rate means the borrowed money costs you more.

For borrowing, the cost is often shown as an APR, the annual percentage rate. It is the yearly rate you pay to borrow. If you borrow 500 dollars at a 20 percent APR and do not pay it back for a year, the interest alone would be about 100 dollars on top of the 500 you owe.

Saving and borrowing are two sides of the same coin. In both, someone pays for the use of money over time. The only question is which side you are on.

• Earning interest: you save or lend, and money is paid to you. Higher rates help you.
• Paying interest: you borrow, and you pay the lender. Higher rates cost you more.
• The longer money is borrowed or saved, the more interest adds up, in either direction.