Money basics - Interest 101 - The very beginning

Interest - the very first lesson.

What is interest?  Interest is the cost of money.   Interest is how much a borrower has to pay a lender for the use of the lender's money.   It's usually stated as a percent.   Let's begin with a simple example:

Jack wants to buy some magic beans.  The beans cost $100.00.  Jack doesn't have any money, but he's gotta have those beans.  Peter's got money and he's willing to lend it to Jack.  Peter will lend the money to Jack at 10% interest.  How much will it cost Jack to borrow the $100?

$100.00 x 10% (or .1) = $10.00.    It looks like Jack will have to pay back $110.00, so the cost of borrowing $100.00 in this example seems to be $10.00.

Is this a good deal for Jack?

Hard to tell, because we really don't yet have enough information.  We need to know the time period to which this 10% rate applies.    We ASSUME that the rate is an ANNUAL rate.  Jack has 1 year to pay back $100.00.  if he waits the full year, he'll pay back $110.00.   Should he get to pay less back if he pays it off before 1 year?

If Jack can turn around and sell the beans for $150.00 right after he buys them, should he pay off Peter right away or just wait the year? If it's going to cost him $10.00 whether he pays it back 1 month later or 1 year later, then maybe Jack should keep the money for the full year. Maybe he can buy more beans and sell them for a profit again and again and again.

If Peter says the interest rate is an annual rate, but Jack can pay him back anytime, then if Jack pays Peter back after 2 months, he should not have to pay a full year's interest, or the whole 10%, he should only have to pay for 2 months of interest.

2 months         x 10% (or .1) this gives us the rate for 2 months  = .016666 or 1.66%
12 months

so the cost to borrow $100.00 for 2 months when the Interest Rate is 10% annually

$100 x 1.66% = $1.66



We need more information than just the rate.  What this will utilmately cost Jack depends on the terms of the agreement for borrowing money.  It's not enough to just say what the interest rate is, we need to know whether the rate is an annual rate or something different, we need to know when and how much is to be paid. How the interest and the loan payments are calculated.  Knowing the Interest Rate is just the beginning to understanding the cost of money.