In our recent study Perceptions and Understanding of Money – 2020, we surveyed Americans to gauge how well they understand the mechanisms of money, including phenomena like interest rates. We hope this “Everything You Need to Know” series will help improve understanding of money-related topics and issues that might not be more relevant today.
Hopefully this particular topic will keep you interested.
What is interest?
The way to start explaining interest rates is to first define interest. Interest is the amount you are charged for borrowing money, or vice versa, the amount you receive for lending money.
Interest charges may be charged if:
- You have student loans
- You have a credit card (or 15)
- You have a mortgage
- You have a business loan
- You have a personal loan
You may also be the beneficiary of the interest. You can collect interest on:
- A personal loan that you have provided to a friend, family member or colleague
- Savings that you have in a bank, as you are expected to lend the amount of your investment to the bank
- Any bonds you own
- Investments in money market accounts
- Funds in your retirement account (s)
From the perspective of the investor or lender, the interest is good. You may find it less beneficial if someone earns interest on your borrowed money. Either way, interest is woven into the fabric of the economy as we know it.
What do interest rates mean?
Interest rates are the percentage you are charged (usually on an annual basis) for borrowed money. Alternatively, it is the rate you get for lending money.
Wait, can’t I earn interest simply by putting my money in the bank?
Yes, you can, but technically you are lending that money to the bank. Banks have the freedom to lend your deposit (and the deposits of other customers)– you will not be bullied) and earn interest for themselves through a process known as fractional backup banking. This means that you essentially borrow your bank money so they can lend it themselves, and you get interest to please them.
When discussing the interest rate that you as an investor receive or must pay to a lender, you need to know how the interest is calculated.
There are two primary ways to calculate interest:
- Simple interest
- Compound interest
When you are charged (or received) simple interest, you pay interest on the amount that you initially borrowed or lent. So if you borrow $ 10,000 at a rate of 10% per month, you should receive $ 1,000 per month until the loan is paid off.
When you are charged compound interest, the interest rate you pay may vary from one payment period to the next, with the cost of the additional interest being factored into your monthly (or annual) payment. So if you borrowed $ 10,000 at a monthly rate of 10%, your initial interest payment will be 10% of $ 10,000 or $ 1,000. If you don’t make your interest payment, the cost of your loan will now be $ 11,000.
With compound interest, 10% of $ 11,000 (instead of 10% of principal, $ 10,000) is now charged as interest for the following month. This means that your interest payment will increase from $ 1,000 to $ 1,100. If you were to pay simple interest, your interest payment would be $ 1,000 over the life of the loan.
Increase the amounts lent or borrowed and even the interest rate, and you have significant consequences in terms of money collected or charged to the borrower by a creditor.
Interest rates: friend or foe?
You may have a love or hate relationship with interest rates, depending on your status as a borrower or lender, or the timing of certain investments you have made.
If you are a net borrower, you may dislike interest in general, and compound interest in particular. This can be especially true for people with one or more high-interest credit cards that never seem to pay them off, student loans that seem to grow rather than shrink (despite graduation being way in your rearview mirror), or other types of high interest debt.
If you’re a lender, interest can be the extra stream of income that you don’t have to work for– handing over that first loan was all you had to do. From Visa’s perspective, your debt is the loan that keeps on giving. But even As a lender or investor, interest rates can confuse you.
Imagine buying a boatload of government or corporate bonds at an interest rate of 3%, and the prevailing rate for such bonds does not rise to 7% until a year later. You make money on interest, of course, but not nearly as much as you could have had you kept an interest rate of 7%.
Remember, at least you are not the one paying the interest. And even if you’re paying interest, keep in mind that there’s always someone with more debt than you (hint: it’s your government).
Interest rates, national loans and cryptocurrency
Like you, your government representatives borrow money. They just borrow a lot more of it, so much so that the total cost of their debt (interest per millisecond, of course) is over $ 26 trillion– and that’s just America.
Suppose you were personally indebted. Your credit score would be virtually nonexistent. And yet, the dollar is based on the “full trust and credit” of a government that long ago pushed its credit potential through the core of the earth.
Those who view this framework as unsustainable have turned to cryptocurrency as a new slate. No massive borrowing, no fiat currency, no unsustainable interest rates, just a peer-to-peer scarcity-based medium of exchange that once defined the US dollar (but now doesn’t). If you’re lucky, your Bitcoin can even be put together before your very eyes.
Interested in owning your own coins? Start mining Bitcoin with us!