Interest is a payment associated with borrowing or lending money. Generally, one party will lend another party a sum of money, called a loan. The receiving party is expected to repay that initial sum–called the principal amount–as well as an additional sum. This additional sum is the interest. Generally, the amount of interest a person must pay is determined by an interest rate, which is a percentage of the principal amount. As stated by the U.S. Securities and Exchange Commission, interest rates may be fixed, which means the rate is set and does not change. For example, if the principal amount of a loan was $100,000, and the interest rate was 10%, the borrowing party would be expected to repay the initial $100,000 plus an additional $10,000. Interest rates may also be variable or “floating,” in which case it may change over time.
The amount of interest a person must pay can vary depending on which person or institution they borrow the money from. For example, according to the National Credit Union Administration, credit unions generally offer lower interest rates on loans than banks do. Additionally, interest rates can vary based on whether the borrowing party is considered low risk–more likely to be able to repay the loan, and in a timely manner–or high risk. This is usually assessed based on the person’s credit score.
Interest can also be gained by persons who deposit money into an institution, like a bank. In this scenario, a depositor gains additional money based on a percentage of the amount of money they have deposited into a checking or savings account. Over time, this can result in compound interest, which is the interest earned on previously accumulated interest.
[Last updated in June of 2020 by the Wex Definitions Team]