What Does Interest Mean for My Financial Health?

By Indeed Editorial Team

Updated February 22, 2021 | Published February 4, 2020

Updated February 22, 2021

Published February 4, 2020

Anyone who has ever taken out a loan or gotten a credit card has dealt with interest. Although it's a common term, interest is not always easy to understand or know what it affects your financial health. In this article, we'll go over what interest is, why it exists and give you some strategies for both paying interest and earning interest.

What does interest mean?

Interest is a predetermined amount of money that is added to your principal balance at regular intervals, most often monthly. When this interest is being applied to the debt you owe, it increases the amount you have to pay, meaning you end up paying more than the amount you borrowed. When the interest is applied to your savings, bonds or investment portfolio, it increases the amount of money you have. The more money you put into these interest-earning accounts, the more interest you will earn.

Interest is typically calculated as a percentage of the total balance in the account. This percentage is then compounded at the end of each set time period. Compounding just means calculating how much interest is added to the balance.

For example, let's say you have a $1,000 loan with a 5% interest rate. After the first month, $50, which is 5% of $1,000, would be added to the amount you owe. The next month, if you paid absolutely nothing, the interest would be 5% of your new balance of $1,050 or $52.50. If, on the other hand, you made a $100 payment, the next month you would be charged 5% on the new balance of $950 or $47.50. As you can see, the actual dollar value of interest changes depending on the current balance of the account when the interest is compounded.

Why is interest important for lending?

Lenders charge interest on the money customers borrow for several reasons. The main reason is to lessen the risk of default. If at some point during repayment, the borrower can no longer make payments and defaults on their loan, the lender just loses that money. Charging interest helps them minimize that loss. This is why borrowers with low credit scores tend to be charged higher interest rates. They are perceived as higher-risk borrowers.

Another reason for charging interest is to account for inflation. On long term loans like mortgages, the amount you initially borrowed will not have the same buying power 15 or 20 years later when you finally finish paying it back. If the loan was interest-free, lenders would end up effectively losing money in the process since the inflation rate has decreased the value of money they lent.

Why is interest important for borrowing?

Interest is extremely important in borrowing. It's what determines how much you actually spend in the end. The longer you take to pay back a loan or pay off a credit card, the more you will end up paying. A $20 sweater you bought with a credit card could end up costing you $30 or more when you account for the interest being added to your balance. So when borrowing money, it's important to have a smart plan in place for repaying in a way that helps you avoid paying too much extra in interest.

How to pay interest

The key to paying interest is to do it as fast as possible. Here are a few tips to avoid paying more than you need to:

  • Pay off the full balance of your credit card

  • Always pay more than the minimum

  • Prioritize debt with the highest interest

  • Avoid predatory loans

  • Get out of a predatory loan as soon as possible

Pay off the full balance of your credit card

If possible, pay off the full balance on your credit card each month. This prevents interest from piling on top of interest. It also has the added balance of improving your credit score by lowering your credit utilization rate (the amount of available credit relative to the amount you have used).

Always pay more than the minimum

You may not have the money to pay off your full balances just yet. Even so, you should at least try to pay slightly above the minimum payment each month. It may not seem like it, but even an extra $5 or $10 above the minimum will save you money in the long run by helping you pay off your debt a little sooner.

Prioritize debt with the highest interest

If you have multiple sources of debt, put as much money as you can toward the one with the highest interest rate while paying only the minimum on the rest. When this high-interest debt is paid off, repeat this with the next highest interest debt.

You don't need to do this if all of your debt is at about the same interest. In that case, you can spread your available funds more evenly to pay as much above each of the minimum payments as possible.

Avoid predatory loans

One of the most difficult kinds of debt to get out of are predatory loans. These are loans that are specifically designed to be difficult to ever fully pay off. The goal of a predatory lender is to keep you locked into that loan for as long as possible so that you are stuck paying interest for longer than you would on a loan with reasonable terms.

There are a surprising number of predatory loans out there and some of them are even coming from seemingly reputable institutions. Even if you are at an established bank, you still want to check the specific terms of the loan you are being offered to make sure you are not being offered a predatory loan.

To avoid predatory loans, here are the red flags you need to look out for before agreeing to any loan:

  • Excessive interest rates: Most loans come with an interest rate between about 5% and 30% depending on your credit score and a few other factors. If the interest rate is higher than that, you should be suspicious.

  • Adjustable interest rates: Many loans, especially those offered to people with poor or fair credit have adjustable interest rates. However, it becomes a predatory loan when that adjustable rate can explode to triple or even quadruple the starting rate and especially when the interest rate cannot go lower. A normal adjustable rate will give you a fixed range, such as 4% to 9%, and have the potential to go down as well as up over time.

  • Targeted ads: These can be tricky to identify but in general, if the ad makes a point of stating that “bad credit doesn't matter,” there is a strong chance it is a predatory loan. There are loan options for people struggling with poor credit but they are usually very small, security-backed loans or prepaid credit cards. You should be especially wary of lenders that try to rush you into signing with limited time offers or who contact you even though you have never applied for a loan with them before.

  • Early payoff penalty: Reputable lenders do not punish borrowers for paying their loan off earlier than anticipated. However, predatory lenders want you to stay in the loan as long as possible so that they can get as much interest out of you as possible. If there is a penalty fee for paying the loan off early, it is definitely a predatory loan and should be avoided.

Get out of a predatory loan as soon as possible

If you are already stuck in a predatory loan, your top priority should be getting out of it. Even if there is an early payoff penalty, it's still worth paying it to avoid all the interest you would end up paying if you stayed in it.

Start researching refinancing options right away. Even if your credit has not improved substantially since you agreed to the predatory loan, you should still be able to find a loan with more reasonable terms.

How to earn interest

Earning interest is one of the best ways to grow your finances. There are a variety of ways to go about it. However, they all come down to what balance between low risk, low interest and high risk, high interest makes sense for your earning goals.

In other words, the more risk you are willing to take, the more you can potentially earn in interest. However, taking a risk means exposing yourself to the possibility of losing that money. If you are not willing to expose your money to this risk, a lower interest but safer approach may be better for you.

Once you've established your goals, you can choose from the following interest-earning options:

  • Interest earning checking account: Although not common, some banks offer checking accounts that pay you interest on the balance you keep in your account. The interest is usually very low but since you need a checking account for your money anyway, you might as well be earning something on it.

  • Savings account: A savings account is a great way to start earning interest and taking charge of your finances. Most savings account only offer about 1%-2% interest rates but if you are good about making consistent contributions to it and don't take money out often, this can definitely add up over time.

  • Certificate of Deposit (CD): A CD is similar to a savings account but with more rules. They offer slightly higher interest rates in exchange for agreeing not to withdraw money for a fixed amount of time such as a year. If you do withdraw from the CD before the term is up, you will forfeit any interest the account has earned. You can, however, add more money to it. Interest rates can vary significantly but are usually between 1% to 3%. In general, the longer you agree not to withdraw from the account, the higher the interest rate they will offer.

  • Retirement account: There are a variety of retirement accounts with the most well-known being an IRA or a Roth-IRA. There are also 401(k)s offered by many employers. These accounts allow you to not only earn interest but usually come with the added benefit of not having to pay taxes on the money in those accounts, for as long as you do not withdraw from them. The amount of interest you earn is not fixed because, unlike a savings account or CD, these are investment accounts so the return varies with the stock market and depends on the specific stock portfolio you are putting your money into.

  • Bonds: Bonds are a kind of “IOU” from the government. You pay the federal government a certain amount of money and, in exchange, the government agrees to pay you back on a specific date in the future with a fixed amount of interest on top. These are considered very safe and carry interest rates ranging from about 2% to 5%.

  • Real estate: Buying property can be a smart investment since you could make money not only from selling it when the value of the property increases, but also from potentially renting it out. However, owning property takes a lot more work than a savings account or a bond. There is also the risk that comes with the housing market's regular fluctuations. When you're ready to cash out, the market might be in a slump, meaning you may not earn as much as you had anticipated.

  • Money market funds: Similar to an IRA but without the tax benefits, a money market fund is basically a financial account that you open with a mutual fund. A mutual fund is basically just a group of investors with similar investment goals who all invest their money in the same portfolio of stocks and then divvy up the interest earned based on the amount each individual contributed. The advantage of this over just investing on your own is that the portfolios are managed full-time by trained fund managers.

Explore more articles