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Glossary
Interest Defined
Most of us are paying and receiving interest at the same time, but to and from different sources.

Interest is something you pay for using someone's money or receive for letting others use your money. Most of us are paying interest and receiving interest at the same time, but to and from different sources. For example, if you have a car loan, you are likely paying interest. If you have a credit card and don't pay off the balance, you are paying interest on the balance. On the other hand, if you have a savings account, you are receiving interest on the amount in your account and, perhaps, if you've loaned money to a friend or relative, you might be receiving interest as the loan is repaid to you. If you are receiving interest, you are the lender; if you are paying interest, you are the borrower.


Interest… From a Lender's (Receiver's) Perspective…

…saving money in a bank is like lending money to the bank, and lenders earn interest.

Interest is the monetary return on money saved or money loaned; it is the benefit of saving money or allowing someone to use your money. A bank pays you interest when you put money into a savings account. This begs the question, why? Because saving money in a bank is like lending money to the bank, and lenders earn interest.


Relationship to Opportunity Cost

Why are savers paid interest? Because money today is more valuable than the same amount of money in the future. If savers are going to allow their money to be used by a bank today, they will want to be compensated for their opportunity cost. If your money is in the bank, you can't use it to buy goods and services now—you give up the goods and services that you could buy today. Those same goods and services will cost you more in the future—so you want interest. The bank uses the money in your account and pays you interest to offset your opportunity cost. Hopefully this means you'll be able to buy the pizzas, vacations and jeans you gave up today sometime in the future.

If you lend your friend money at a specific interest rate, that means you no longer have that money to spend on goods and services until you are repaid. Your opportunity cost is your next-best alternative for the use of that money. If you would have used the money you loaned your friend to, instead, buy a new phone, then your opportunity cost is having the new phone now.

Loan Default

Interest also compensates the lender for the risk that the borrower may not pay him back — the greater the risk that the borrower might default on the loan, the higher the interest rate. Default is the failure to promptly pay interest or principal when due.

Which of these loans do you think would carry the greatest risk of default?


Interest… From a Borrower's Perspective…

Interest is the amount of money paid by the borrower to the lender for the use of the lender's money. Borrowing might be in the form of a personal loan, like your brother borrowing $100 from you. You could borrow money from a bank for a car or, someday, a house. In each case, the borrower pays the lender a monetary return called interest.


Relationship to Opportunity Cost

If you don't have enough money for things you want, you may be able to borrow it. But, as the borrower, you have to pay interest to the lender to compensate the lender for his or her opportunity cost. You get the money you want, but you give up things you could have in the future. Every interest payment you make represents some good or service that you cannot have. Your opportunity cost is, as yet, unnamed stuff in the future. So, before you take out a loan, ask yourself, "Is it really worth it?"


Key Points

Interest can be looked at from a couple of perspectives, depending on whether you are on the receiving end or the paying end. From a receiver's perspective, interest is the monetary return on saving. It is the amount of money that can be earned by putting money in a savings account or other investment. Saving money in a bank is like lending money to the bank, and lenders of all sorts earn interest. Lending might be in the form of a personal loan, like the $100 loan to your brother. It might be in the form of a loan to a corporation or the government. This lending is referred to as a bond. Or, it may be a bank lending money for a house or car. In each case, the lender receives a monetary return called interest.