Personal Finance
Lesson 8
3 min

What is interest?

In the context of investing, interest is the amount you, as an investor, earn for placing your money in an investment or a project. In the context of borrowing money, it is the amount you, as a debtor, pay for borrowing money.

  • Interest is calculated based on the original amount of money that you invest 

  • The interest rate is a percentage representing how much and over what time period the bank wants to charge you for lending you money as a loan or to give you for depositing your money in a savings account

  • If you invest your money in interest-generating assets, you will earn interest on that amount, and a later stage, compound interest

  • Compound interest is interest that is created from interest that is already credited to an account - interest on top of that which already exists

In this lesson, you are going to learn about what interest is and why it is important in making investment decisions.

The origins of interest

According to historical sources, committing resources to achieve a return was first documented as early as around 1700 BC in the Code of Hammurabi. Hammurabi, ruler of Babylonia had drawn up a code that was to apply to his entire empire and the code was carved into a stone stele. Today, this stele is on display in the Louvre in Paris, France. The Code of Hammurabi states that “A merchant may collect interest of thirty-three and one-third per cent on a loan of grain, and twenty per cent interest may be charged on a loan of silver.”

A closer look at interest

In the context of debt, interest is an amount of money that the debtor - the person borrowing the money - pays the creditor - the person or institution lending the money - in return for temporarily lending the amount borrowed, the capital, for a certain amount of time. 

The amount of interest due for a debtor or paid to an investor is calculated as a percentage of the loan balance or the deposit balance. The interest rate is pre-determined or calculated by the creditor using this set percentage. 

This is the formula commonly used for the most basic calculation for simple interest:

Simple Interest = P (Principal amount, the original amount of money) x R (Rate of interest) x Time (Duration of loan/investment period)

Let’s assume our investor deposited EUR 15,000 in a savings account earning 2 percent (0.02) interest for five years. So, the interest the investor earns over five years is: 15,000 times 0.02 times 5, which amounts to EUR 1,500.

 
 
 

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Remember that investing means putting money into something in the hope of achieving a gain from it? In the context of asset generation, interest is the amount of money an investor receives for placing their money in a savings account. For this, they are paid interest.

The amount of interest due for a debtor or paid to an investor is calculated as a percentage of the loan balance or the deposit balance. 

Understanding compound interest

However, really clever investors thinking about the long term don’t rely on earning simple interest but use the power of compound interest to increase their wealth. They earn interest over the long term, called compounding, which is the equivalent of “magnifying”. This is achieved with discipline and perseverance. But how does the compound interest effect differ from a simple interest rate? Find out in our next article on how compound interest is generated. 

FURTHER READING 

BOOKS

  • Fisher, Irving - The Theory of Interest as Determined by Impatience to Spend Income and Opportunity to Invest It

  • Homer, Sidney - A History of Interest Rates

Hammurabi’s Code of Laws

The history of investing

Investment and the rate of interest

Simple Interest - overview and calculations

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