From the cost of a mortgage to the return on savings, interest rates play a significant role in our financial lives. Understanding how they work helps you manage your debt and make smarter investments. However, it can be difficult to keep up with how different financial instruments and account types utilize and calculate interest. There are many variables, including the type of loan, its duration, and whether it is secured or unsecured. The difference in the calculation of the true cost or return on a loan can be caused by personal factors such as a borrower’s creditworthiness, or by economic trends and the Federal Reserve’s benchmark interest rate.
The concept of interest is a fundamental one, and has been around for a long time. It is a charge to the borrower for using someone else’s money or assets, and it also rewards those who save their hard-earned money. The amount of interest charged or earned is determined by the amount borrowed, lent, or saved over a specified period of time, which is typically a year. The resulting amount is then added to the principal. This is referred to as compound interest.
The most common forms of interest include simple and compound. The former is a straightforward method that only applies interest to the principal, and does not account for accumulated interest on previous amounts owed or earned. Compound interest is a more sophisticated method that takes into account accumulated interest and charges or payments, and can be a lucrative tool for growing your savings.