6 things a new investor needs to know about ‘interest’ in finance — No financial jargon

6 things a new investor needs to know about ‘interest’ in finance — No financial jargon

Have you just started your investment journey? Surely you must be hearing the terms ‘interest’ and ‘interest rates’ everywhere.

As a person who is kicking off their investment journey, you’d find it useful to learn as much as you can about finance and how it works.

So, here are 6 things about the financial term ‘interest’ and how it affects your money.

1. What’s ‘Interest’?

Look at this story.

Mr. Credit Charles is in sudden need of cash. So, he goes to Mr. Funds Freddie and asks him if he could borrow $1000.

Now, Mr. Funds Freddie was planning to take a road trip with that money because he’s got enough for all his expenses. So, if Mr. Credit Charles wants to borrow $1000 he should not only return the $1000 but also an additional payment to compensate Mr. Funds Freddie for skipping the road trip and lending him the money.

Plus, he has to give Mr. Funds Freddie a little extra for the risk he’s taking in lending the money to him. After all, Mr. Credit Charles could slip away with the cash and not return it at all.

The total of these extra bits that Mr. Credit Charles is obligated to pay Mr. Funds Freddie as a fee for taking his money is called ‘interest’

2. What’s ‘interest rate’?

Interest rate is simply how much extra you can get when you lend your money to a borrower. For example, say you lend $100 to someone for a year and tell them that your interest rate is 10%. It’s very simple maths. You’ll get back $110.

The interest rate you charge will depend on how much compensation you want for letting go of what you could’ve done with that amount. It also depends on the size of risk you’re taking in lending your money to the debt taker.

If you feel the debtor isn’t the most reliable guy, you’ll want to charge him a higher interest rate. Your risk level is higher.

3. Why do banks pay you interest on your deposits?

When people deposit their money in a bank, the bank knows that not everyone is going to withdraw all the money all at once. So, banks keep a certain percentage of the total deposit and use the rest to make loans to borrowers!

And when the borrowers repay the bank with interest, banks keep 1–2% of the interest and offer the rest to you. This is how banks make money and pay interest to savers.

4. Two types of interests

You would’ve studied in school. There are two types of interests.

1. Simple interest

2. Compound interest

Simple interest

Assume you deposit $100 into a bank that offers a simple interest rate of 10% per annum for 5 years.

This means that every year for the next 5 years the bank will put into your account 10% of $100, which is $10. At the end of 5 years, you can withdraw $150 from the bank.

Compound interest

Here the interest is calculated differently. You deposit $100 into a bank at a compound interest rate of 10% per annum for 5 years.

For the sake of convenience let’s use the right financial term for deposit: principal.

In the first year, your principal gets an interest payment of $10. But right after this, the $10 gets added to your original principal of $100 and the principal for the second year becomes $110! So, the second year will earn you an interest of 10% of $110 which is $11.

What happens next? You guessed it. For the third year, the principal is now $121.

This process of adding the interest to the principal and paying interest on the new principal — compounding, continues till the completion of the term of your deposit. In this case, at the end of 5 years, you’ll be able to withdraw $161.05!

As you can see, investing on compound interest earns you more than simple interest.

5. Interest on the loans you take

 By now you know that if you’re taking a loan from a bank, you can do it only under the condition that you pay interest. So, how do banks work out the interest rate at which they can lend you money?

Banks have to pay interest to their depositors. Additionally, they’ve their own operating costs like building rent, salaries, electricity bills and a host of other things.

A bank also needs to take into consideration how long you’ll take to repay the loan. This is important because the longer the period of your repayment, the greater risk the bank has in lending to you. The bank has no way of knowing if a person will pay his instalments 10 years from now. So longer periods mean higher interest rates.

After considering all these things banks will work out loan deals that you can pick up like how you’d pick a product off the shelf.

And in case you don’t repay, your interest may get compounded like a credit card debt depending on the terms you agreed with the bank. So, you’ll end up paying a lot more in case you miss your instalments.

6. Interest rates on the news

Every now and then you’ll hear in the news that the Central Bank of some nation is tampering with the interest rates in its country. You’ll have also noticed that different banks offer loans and deposits at different interest rates. What does this all mean?

The reality is that the world of finance has different kinds of investment and lending institutions. There are establishments that don’t take deposits at all but give loans to businesses by borrowing elsewhere. There are just depository firms and credit unions. The list is endless.

The point to note: each one offers and lends different financial contracts at different interest rates.

The Central bank of a nation has the responsibility to manage inflation and keep the economy healthy. If the interest rates are too low, there will be too much borrowing, too little deposits leading to hyperinflation and subsequently to a financial crash.

If the rates are too high businesses will hesitate to borrow. Hence, they won’t expand and new jobs won’t be created leading to unemployment.

What does the Central Bank do? It tweaks one of the interest rates — the rate at which banks borrow from each other. When the Central Bank does this, all the other financial institutions will be forced to tweak their respective interest rates. This is why interest rates make big news.

Unfortunately, the control that a Central Bank exercises over the interest rates and subsequently the entire financial system has led to several financial crises. Click here to read how the 2008 financial crisis happened and how decentralised finance is trying to address the loopholes in the current financial system.