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  • 4m.

    How Does Interest Work?

    Interest is basically the cost of borrowing money. Depending on the account you have, interest can increase the amount you earn (like with a savings account) or the amount you owe (like with a loan).
    Updated: September 15, 2016

    What You'll Learn

    • How lenders charge interest, and why.
    • When interest is a good thing for you.
    • How to figure out when your savings will double in value.
    A watch on a dollar bill

    If interest intimidates you, you're not alone. Lots of people have trouble grasping exactly how it functions. However, interest really isn't all that complicated once you understand the basic concept behind it—it's the cost of borrowing money.

    Small Amounts Add Up Over Time

    Let's say your friend wants to borrow $20. In addition to receiving your $20 back, you should get something in return for giving up your hard-earned cash, right? (Besides your friend's appreciation, of course.) That "something" is interest; basically, it's a fee that lenders charge borrowers.

    If you've ever borrowed money for a house, a car, or a student loan, or if you've ever had a credit card, you likely paid interest on it. The actual amount you paid would have depended on a couple factors: your loan's interest rate and how long you've been in repayment.

    Interest rates determine what percentage of the balance (or the amount owed at any given time) that the borrower is charged. These rates can be fixed (i.e., they always stay the same) or variable (i.e., they can change based on different factors). They can also be simple (i.e., based only on the principal loan amount) or complex (i.e., based on the principal loan amount and any previously earned interest added to that amount).

    Regardless of these factors, what you need to know is that interest typically accrues on a loan, usually either daily or monthly, until the loan is completely repaid. This increases the amount borrowers have to pay back—and it can have a significant effect on monthly payments, especially for borrowers who are in repayment for a while.

    Your Bank Borrows Money From You

    Now, interest isn't always a bad thing. As an incentive to get you to open certain types of accounts, financial institutions pay interest to customers, too. When you put your money in an interest-bearing account, the bank or financial institution holding your money essentially borrows that money from you.

    They use those funds to provide mortgages, auto loans, and other financial offerings to their customers (charging them interest along the way). The amount of interest banks pay their customers is usually lower than the amount they charge the people who borrow from them—that's how banks make money. However, it ensures banks always have money on hand for you, even though they've likely loaned the actual money in your account to another customer.

    Sure, the amount of money your account earns is usually fairly small, especially if your interest rate is low or you don't keep much money in your account. Still, that interest will keep growing, and it could become substantial if you give it enough time. Eventually, your money could even earn enough interest to double in value!

    The Rule Of 72

    When you leave your money in an interest-bearing account, that investment can multiply. To figure out how long it will take your dollars to double, you only need to know your magic number—72.

    "The rule of 72" is a simple mathematical formula you can use to calculate how many years it will take to double your money: just divide 72 by your interest rate.

    The greater your interest rate, the faster your money doubles. For example, let's say you get $3,000 in cash as graduation gifts or a bonus at work. After spending $1,000 paying down some student loans, and another $1,000 to buy furniture, you invest the remaining $1,000 in a new online savings account with a 3% interest rate.

    How long do you have to wait for a second $1,000 to appear in your account? Simply plug your interest rate into the rule of 72, and you can calculate how long it will take for your investment to double.

    In this example, your hypothetical $1,000 will take 24 years to double. In other words, if you make this $1,000 investment when you're 21 years old, it will grow to $2,000 by the time you turn 45. So, while you may think that money is simply collecting dust, it's actually gathering something much more valuable—more money for you!

    Math isn't your strong suit? Try our rule of 72 calculator to easily figure out when your money will double!

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