Saving Money 101: How Does Interest Work?,

Regardless of when you first start saving and investing money, you will need to learn some basic financial practices and terms. One of the most important to understand is the concept of “interest.”

What is interest?

The most simple definition of interest is that it is a percentage of a certain amount of money.

But how does that work in practice? 

Imagine that you want to borrow the money to buy a car. If you go to a bank and ask for a loan of $1000, they may lend it to you, but they will also charge you because they are providing you a service. In giving you a loan, they will give you, right away and in one lump sum, $1000. Because they are providing a service, they will make an agreement with you that not only will you pay back the full thousand dollars to them at a specified future time, they will also charge you interest. Say the bank loans you $1000 at an interest rate of 10%. (That 10% is the interest, or the percentage, on the certain amount of money, the thousand dollars.) If you must pay them ten-percent interest, that means that over time you will not only pay the bank back $1000, you will also pay them (according to the timing and terms they set) an additional $100 in interest. By the time you pay back the loan, you will give the bank a total of $1100, rather than just the original $1000 they loaned you.

Interest is also money that can be paid to you when you save or invest your money. If you make an agreement with someone that you will save your money in their institution (in effect, saying you will lend a bank or other investment house your money), they will pay you interest. To follow the same example above, if you deposit $1000 in a bank and receive 10% interest annually, then each year you leave your money in that institution, they will pay you $100 in interest on that thousand dollars you “loaned” them.

Sounds simple! 

The examples above greatly simplify how interest transactions can happen. The simplest types of interest, such as the one described above, are calculated on a yearly basis and are called “annual percentage rates” (APR). Again, the technical definition for an APR sounds complicated: the yearly interest generated by a sum of money.

That simply means that the $1000 you invested in, or lent to, your bank or financial institution, at 10% interest, has an annual percentage rate of 10%. APRs can be calculated in slightly different ways (you’ll see why in a minute), but they can be useful starting information because institutions are required to disclose their APRs to their customers. Asking the APR of one investment that you want to make will allow you to judge which institutions are paying the most interest to you. You want, when saving your money, to receive the highest interest rate possible, because that is how you will make the most money.

Here is another example. If you are researching two banks as a place to invest your money, and one bank’s investment product (what it is called when you choose a certain way to invest your money with any financial institution) offers you an APR of 5%, and another bank offers you an APR of 10%, you would choose the 10%. For the first APR, your one thousand dollars would get you a return of $50. For the 10% APR, that same thousand dollar investment would get you $100.

Here’s where it gets more complicated

Interest is often calculated and paid, not once per year, but at several times throughout the year. All of the interest rate calculations above would count as “simple” interest, or a set interest rate that is calculated only on the set amount of the money loaned (or borrowed).

Another type of interest is known as “compound” interest. This is interest that is calculated on the original sum of money, but also on the interest periodically paid on the initial amount.

Too much information? 

Think of it like this. If you put $1000 in the bank, in an investment (such as a certificate of deposit, or CD) that pays a compound APR of 10%, and you agree to let the bank keep that money for a set amount of time, like three years, this is how your compound interest will be paid to you:

At the end of the first year, you will be paid $100 on $1000. Now you have $1100. At the end of the second year, you will be paid 10% interest on $1100, which equals $110. Now you have a total of $1210 dollars. At the end of the third year, you will receive 10% of $1210, or $121. At the end of three years that investment would be worth $1331.

The same investment, if you had only been paid a simple 10% rate of interest, would have been worth $1300 at the end of three years (the original $1000 plus three years of $100 per interest each year).

That may seem like a small difference, but if you start with larger numbers and calculate them over longer periods of time, you will see that an investment that pays a compound interest rate to you will make you more money.

There are also differences in the way investment products calculate compound interest. Some common compound interest payment schedules are annually (once per year), quarterly (once every three months), or monthly (once a month). Every time compound interest is calculated and paid, it makes the number of your original investment larger. Hence, an investment that compounds and pays interest monthly will give you the best rate of return for your money.

So what types of investments offer interest?

The most common financial product that pays an individual interest is the certificate of deposit (CD). A CD is basically a loan you make to the bank or financial institution offering it. You put $1000 in a CD, giving the bank your $1000 to use or invest as they see fit. CDs are often offered for certain amounts of time: 3 month, 6 month, 1 year, 2 years, 5 years, etc.

For as long as your money remains in the CD, the bank pays you interest on your money. When the term of the CD is up, you can take back your original investment of $1000, plus the interest the bank paid you.

Other products to learn more about that may pay you some amount of interest include saving accounts, money market accounts, interest-paying checking accounts, and short-term bonds and treasury bills.

The most important thing to do when you have money to invest is to learn the terminology of the investment and financial world. If you can understand interest, you are well on your way to understanding other financial terms and tools as well!

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