Money Bytes · Episode 3 · Money basics
Interest: renting money
Interest is rent for money. Borrowers pay it to use someone else's money, savers earn it when the bank uses theirs, and the interest rate says how big the rent is each year.
Renting money
When you rent an apartment, you pay the owner for the right to use something that isn't yours, and you give it back when you're done. Borrowing money works the same way. The lender lets you use their money for a while, you pay it back later, and on top you pay a fee for using it. That fee is interest. The amount you borrowed is called the principal.
A worked example
Borrow $1,000 at 10% a year. After one year you pay back:
- the principal: $1,000
- plus interest: 10% of $1,000 = $100
Total: $1,100. The $100 is the rent for having the money for a year. This is simple interest: it's figured only on the original $1,000.
Saving flips it
When you put money in a savings account, you become the lender. Banks use deposits to fund the loans they make to other people, and they pay you interest for the use of your money. Borrowers pay the bank interest, and the bank pays savers interest, usually at a lower rate. The gap between the two helps the bank cover its costs and earn a profit.
The interest rate
Interest is quoted as a percentage per year: the interest rate. The higher the rate, the bigger the rent on the same loan. On $1,000 for one year:
- at 5%: $50 of interest
- at 10%: $100
- at 20%: $200
That's why the same loan can be cheap or expensive, and why comparing rates matters before you borrow.
Try it yourself
Find the interest rate on a savings account or credit card you (or your family) have; it's usually on the statement or the bank's website. Work out the rent on $1,000 for one year: rate ÷ 100 × 1,000. Which is bigger, the rate you'd earn saving or the rate you'd pay borrowing?
Good to know
- The $1,000 at 10% example is simple interest for one year, paid back in one lump sum. Real loans usually have monthly payments, fees, and an APR (annual percentage rate) that can differ from the stated rate.
- "The bank uses your savings to lend to others" is simplified: banks don't lend out a specific deposit one-for-one.
- Savings rates are typically far lower than loan rates; the gap is the bank's margin.
- In the US and Canada rates are quoted per year. The central bank's policy rate (the Federal Reserve, the Bank of Canada) pushes loan and savings rates up or down.
- Educational only, not financial advice.
Test your knowledge
Quick quiz: Interest: renting money
4 multiple-choice questions. Pick one answer for each, then check how you did.
Sources
- Federal Reserve Bank of St. Louis, "Lesson 6B: Simple and Compound Interest": interest as the price of using money; simple interest on the principal
- FDIC Money Smart, "Chapter 5: Compound Interest": banks pay interest on deposits; the interest rate as a yearly percentage
- CFPB, "What's the difference between a simple interest rate and precomputed interest on an auto loan?": how interest on a loan is charged
Video transcript
Interest is just rent. For money.
When you rent an apartment, you pay the owner to use something that isn't yours. Borrowing money works the same way.
Borrow $1,000 at 10% a year, and after one year you pay back the thousand, plus $100 of rent. That rent is interest.
It flips when you save. Put money in a savings account, and the bank uses it to lend to others, so the bank pays you rent.
The rent is quoted as a percentage per year: the interest rate. Higher rate, bigger rent. That's why the same loan can be cheap or expensive.
That's your bite. Next: how interest can earn its own interest.