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Interest: Definition, Example and Related Terms

What is Interest ?

Interest, in the context of financial and contractual agreements, refers to the cost of borrowing money, typically expressed as a percentage of the principal loan amount per period, usually an annual rate. It serves as a payment from the borrower to the lender for the use of borrowed funds. The interest rate can be fixed, remaining the same throughout the loan term, or variable, changing with market conditions.

For example, if a business takes out a loan to purchase new equipment, the bank may charge them a 5% annual interest rate on the borrowed amount. This means that annually, the business will pay 5% of the original loan amount in addition to repaying the principal.

Understanding interest is crucial, especially when dealing with loans, credit, and other financial instruments. The interest rate can significantly affect the total cost of a loan, influencing both budgeting and financial planning.

Additionally, interest can also apply to interest earned on investments. When you invest money, you earn interest, which can be considered income from your investments over time. This applies to savings accounts, bonds, and other financial instruments.

Example(s)

  • Scenario Description
    A startup takes a $10,000 loan from a bank with a 7% annual interest rate. The startup will pay $700 in interest annually, alongside any repayment of the principal, until the loan is fully paid off.
    An individual deposits $5,000 into a savings account that offers 2% interest compounded annually. Over a year, the account will earn $100 in interest, with the amount compounding annually to increase future interest earnings.