What Is Interest and How Does It Work?

What Is Interest and How Does It Work? article image.

Interest is a cost that a borrower incurs for the privilege of borrowing money. Interest is generally expressed in the form of an annual percentage known as an interest rate. Depending on the type of debt you have and your creditworthiness, interest rates can be high, low or somewhere in between. Here's what you should know about how interest works and how to avoid interest charges—or at least minimize them.

How Does Interest Work?

When you borrow money, lenders often charge interest on your balance until you've paid your debt in full. When shopping for a lender, you may see interest rates expressed on their own or as an annual percentage rate (APR), which factors in fees charged on the debt as well as interest. Credit card APRs do not include fees, however.

The way interest works and how it's applied to your debt can vary by the type of credit and the lender that originated the loan. For starters, lenders may choose to use simple interest or compound interest on their loans. With simple interest, interest is only applied to the principal balance. So if you have student loans, which typically use simple interest, your loan may accrue interest every day, but it's calculated using only the interest rate and principal balance.

With compound interest, the lender calculates interest on the principal balance and also on the interest that's accrued since the last payment. So as interest accrues each day, the daily amount that's added to your balance increases.

Depending on the type of credit you have, interest can be applied differently.

For example, most credit cards don't charge interest as long as you pay your balance in full by the monthly due date. If you don't pay in full, you only pay interest on the amount that remains after the due date.

With installment loans, including auto loans, mortgage loans, student loans and personal loans, it's typical for the interest to be automatically rolled into your monthly payment. As a result, a portion of your payment covers the interest that accrued since your last payment, and the remainder goes toward paying down your loan's principal balance.

Pros and Cons of Interest

While paying interest isn't always ideal, there can be some benefits to using credit. That said, there can be some significant drawbacks, especially with high-interest credit products.

Pros

  • It allows you to finance large purchases. In an ideal world, no one would need credit to buy a home, a car or other large purchases. But that's not an option for most people. So while paying interest may not be super appealing, it makes it possible for people to obtain housing, transportation and other important things.
  • You can leverage your money. If your credit is in great shape and you can qualify for low-interest loans, you can use that opportunity to leverage your money. For example, let's say you can get a 2.5% interest rate on an auto loan to buy a $20,000 car, or you can pay for it outright with cash. With such a low interest rate, it may make more sense to put some money down and use the rest of your cash to invest and earn more in returns than what you would've saved by buying the car in cash.

Cons

  • Some credit products are expensive. If your credit score is low, you may have a hard time qualifying for low interest rates. The higher the rate, the more pressure your monthly payment will put on your budget. Even if you have great credit, interest rates can vary depending on the product you choose. For example, the average 30-year fixed mortgage interest rate as of September 16, 2021, was 2.86%, according to Freddie Mac. With personal loans and credit cards, average rates were 9.58% and 16.30%, respectively, according to Federal Reserve data from May 2021.
  • Interest can cause your balance to increase. Making low monthly payments on an account that has a high balance and high interest could cause your loan balance to actually increase over time instead of decrease. This can happen when you're on an income-driven repayment plan for federal student loans, for example.

How to Avoid Interest Charges

The best way to avoid interest entirely is to never borrow money. But that's not feasible for many people, so it's important to know how to minimize your interest costs.

If you have a credit card, you can avoid interest by always paying your monthly bill on time and in full during your grace period. Also, avoid cash advances, which start accruing interest immediately.

With other types of credit, including mortgage loans, auto loans, student loans and personal loans, interest is unavoidable. However, there are steps you can take to reduce how much you have to pay:

  • Establish good credit. Higher credit scores correlate with lower interest rates. So take some time to get an idea of where you stand by checking your credit score and credit report. If your score needs some work, review your credit report to identify and address the issues that may be bringing your score down. Common strategies for improving credit include paying down high debt balances and bringing past-due accounts up to date.
  • Avoid unnecessary credit. Personal loans can be appealing because they can be used for just about anything. These loans can also be used to consolidate higher-interest credit card debt. If you're thinking about getting one to book a vacation, make some home improvements or make a large purchase, you're usually better off waiting until you can afford to cover the cost with cash. With home improvements, in particular, a lower-cost home equity loan or line of credit may be better.
  • Avoid overborrowing. In situations where you plan to borrow, take steps to minimize the amount of your loan. For example, if you're buying a home, making a large down payment reduces how much of the purchase you have to finance and, therefore, your total interest charges. Also, consider picking a more modest home or vehicle if you're planning to finance that purchase so it doesn't put too much strain on your budget. Don't be tempted by a longer loan term, either—even if it reduces your monthly payments. This typically means paying more in interest by the time the loan is paid off.

Monitor Your Credit to Maintain Low Interest Rates

Building credit is crucial to helping you qualify for favorable interest rates. But once you reach a good level with your credit score, it's important to avoid getting complacent. Otherwise, you could miss some problems that can wreak havoc on your credit history.

The good news is that you don't necessarily have to check your credit score and report constantly to stay on top of your credit. Experian's free credit monitoring service offers alerts when new information gets added to your credit report, such as inquiries, new accounts and personal information.

You'll also get free access to your credit score and your Experian credit report, which you can view anytime you want.

As you stay on top of your credit through alerts and checking occasionally, you'll be in a better position to maintain the result of all of your hard work.

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