What Is Interest?

To put it simply, interest is the cost of borrowing money.

Let’s just say I want to spend $1 on a cone of ice-cream right this moment. But then, a friend of mine asked to borrow $1 from me. I only have that $1 coin and nothing else. Shall I decide to lend my coin to my friend or use it to buy my ice-cream cone? (Let’s just assume that I am not so nice and that I really don’t want to lend that $1 to my friend).

So, there are 2 things that can happen.

  1. I do not lend the $1 to my friend. I get to spend it immediately.
  2. I lend $1 to my friend and I do not get to spend it until she returns it to me.

BUT, why would I want to let go of the immediate satisfaction of getting my ice-cream cone right now?

The answer is: there’s got to be something in it for me. And that, my friend, is Interest. The “something in it for me” is that I should get “paid” for sacrificing my own use of the $1. So, my interest could be 10 cents per week.

That means, for every week that my friend has not returned the $1 to me, she will have to add 10 cents to the borrowed money. So if she pays me after 1 week, I will get back $1 (which is called “the principle”) plus 10 cents (which is called “the interest”). If she pays me back only after 2 weeks, I will get $1.20 and so on.

Note: However, interest rates are usually expressed as percentage rather than in cents or dollars. The above illustration is for you to understand the concept of interest.

So, what does interest have to do with saving?

When we put our money in the bank, the bank wants to pay us back for entrusting our money with them, so they pay us a bit of interest. Not much, but it’s better than if we were to keep all our money in a safe at home where we will earn zero interest.

Where does the bank get the extra money to pay us in terms of interest?

Well, it’s time you learn that banks don’t just park all our money in a vault. They use our money to invest in other things that will give them returns. They will then take some part of that return to pay us interest.

In a way, banks “borrow” our money to make more money.

To learn more about how banks work, click here.

Anything not clear, ask me in the comment section below!

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