What Is Interest and How Does It Work?

By Upstart Content Team | Updated December 10, 2022
reading time 4 min read
Elderly woman sitting on bed with laptop learning about interest

Key takeaways: 

  • Interest is the money you’re charged to access funds or credit, like a personal loan or credit card, respectively.
  • Interest rates may be simple or compound. Compound interest is more common—and typically more costly—than simple interest.
  • Factors like the Federal Reserve’s rates, your credit history, and the length and amount of your loan can impact your interest rate.

Whether you’re new to credit or an experienced borrower, you’ve likely heard the term “interest” floating around. Interest is a key feature of most kinds of credit, and it can have a significant impact on how much your loan will cost.

With that in mind, it pays to understand what interest is and how it works. In this guide, we’ll take a closer look at interest as it applies to borrowing. We’ll also discuss the most common types of interest, along with the factors creditors consider when setting your rate.

What is interest?

Interest is the amount of money you’re charged in exchange for access to credit. Interest is typically expressed as a percentage of the amount you borrow, known as the interest rate. 

And the annual percentage rate (APR) is the total amount you’ll pay each year in interest and fees.

You can owe or earn interest, depending on whether you borrow or loan money. If you take out a loan, you’ll likely have to pay interest to your loan provider. But if you put money in a savings account, your bank may pay you interest in exchange for using your money.

How does interest work?

Interest is typically added on top of your debt principal, or your original loan amount. It applies to virtually every form of debt, including personal loans, mortgages, auto loans, credit cards, and more.

Interest charges usually mean you’ll end up paying your lender more than you originally borrowed. For example, consider the following loan breakdown.

Say you take out a $5,000 personal loan with a 10% interest rate, a 5-year term, and a base monthly payment of $83. When you add interest, your payment increases to $106 per month. By the time you reach your payoff date, you’ll pay about $1,300 in interest—bringing your total cost to $6,300.

Loan principal: $5,000
Interest rate: 10%
Term:  5 years (60 months)
Base monthly payment: $83
Principal + interest payment: $106
Total interest $1,374
Total cost of loan $6,374

Pro tip: Higher interest rates often lead to more expensive debt, while lower interest rates make the cost of borrowing more affordable. It’s important to consider the rate of a loan or credit card before taking on more debt. You can also use a loan calculator to get an estimate of how much you’ll spend over the life of the loan.

Types of interest

Creditors may apply two main kinds of interest to debt: simple interest and compound interest. Let’s take a closer look at each.

What is simple interest?

Simple interest is based on the principal amount of your loan. You can calculate simple interest by multiplying the loan principal, interest rate, and loan term. If you take out a $10,000 loan with a simple interest rate of 5% and a 5-year term, your interest payments would total $2,500 over the life of your loan.

What is compound interest?

Compound interest is based on both the loan balance and its accrued interest. You can think of compound interest as “interest on interest.”

Compound interest can be calculated daily, weekly, monthly, or continually. Therefore, it often leads to higher costs for borrowers. For instance, consider the loan described above. If you exchange the simple rate for a compounding interest rate, you would owe about $2,800 in interest.

What is accrued interest?

Accrued interest is the amount of interest you’ve collected since your last payment. Most loan providers charge interest daily. Rather than forcing you to make daily payments, these charges are tracked and added to your monthly installments. 

Part of your monthly payments go toward your accrued interest. The rest goes to your principal balance.

How interest is determined

Financial institutions calculate interest based on several factors, including:

Lenders also consider the borrower’s level of risk when determining interest rates. Your risk level is based on details like your repayment history, credit score, and borrowing habits. 

If you have a history of solid financial habits and a good credit score, you’re more likely to get approved for a loan with a lower interest rate. If your credit could use some work,  you may only qualify for a loan or credit card with a higher interest rate. 

Lending marketplace like Upstart, look beyond your credit score and use your work experience and education¹ to help you find a personal loan

Who pays interest on a loan?

The borrower is responsible for paying interest on debt, whether it’s a personal loan or a revolving credit card balance. Some credit card or loan companies offer a 0% introductory interest period, which may allow you to save money on interest. However, you’ll have to pay interest as soon as the introductory period closes.

Feeling empowered to make the most of your credit?

Interest is one of the most important factors to consider when taking out a loan. But it can be confusing, especially if you’re not sure how it works.

After reading this guide, you can feel more confident in your ability to identify interest rates, get a rough estimate of your total costs, and understand if you’re paying simple or compound interest. 

If you’re still not sure what kind of interest rate you might face on a loan, reach out to your creditor for more information. That way, you can make an informed decision and get one step closer to a solid financial future. 

¹Neither Upstart nor its bank partners have a minimum educational attainment requirement in order to be eligible for a loan.

This content is general in nature and is provided for informational purposes only. Upstart is not a financial advisor and does not offer financial planning services. This content may contain references to products and services offered through Upstart’s credit marketplace.

About the Author

Upstart Content Team

The Upstart Content Team shares industry insights, practical tips, and borrower success stories to help people better understand the important “money moments” of their lives.

More resources you may be interested in

What Is a Personal Loan Origination Fee? Is It Worth Paying?
Does Refinancing Hurt Your Credit? What You Can Expect
What Is a Credit-Builder Loan and How Does It Work?

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