Interest is defined as the cost for purchasing borrowed money. Interest can refer to:
- The price paid by borrowers to lenders.
- The amount earned by investors in deposited funds.
Hence, it can contribute to both income and expense.
There are three types of interest rates.
- Simple interest rates depend solely on the principal amount.
- Compound interest rates compute interest based on the principal amount plus the accrued interest. Compound interest rates can lead to ballooning loans if payments are not made regularly. If the interest will add to your income—for example, in investments and savings accounts–then you should go with compounding interest. This way you money will grow faster.
- Amortized interest is computed based on the remaining balance. This means that if payment on amortized loans are made regularly this results in smaller interest. However, it also means that non-payment can lead to increased interest if penalties are added to the principal due to late payment. If interest will add to your expense (i.e. loans) then make sure to avoid those that levy compound interest rates (i.e. credit cards) and go for amortized loans instead.