Understanding Interest Rates

Definition of Interest

• Interest is a fee paid by a borrower to the lender for borrowing money.
• Interest Rate is the percentage that the borrower pays to the lender.

Example: Ben's Education Loan

• Ben, a recent high school graduate, needs to borrow money for university tuition.
• He takes a loan of $50,000 from the bank.
• The bank charges an interest rate of 5% per year.
  • This means Ben pays $2,500 in interest annually.
• Interest can be thought of as paying rent on borrowed money.

Example: Ben's Savings Account

• Ben saves $10,000 in a savings account at the bank.
• By keeping his money in the bank, he is lending it to the bank, which can then use it for investments or loans.
• The bank pays Ben an interest rate for keeping his money.

Compound Interest

• Interest can also gain interest over time, known as compound interest.
  • E.g., If interest rates are 5%:
    • Year 1: Ben earns $500 on his $10,000 principal (total: $10,500).
    • Year 2: Ben earns $525 on $10,500 (total: $11,025).
    • Year 3: Ben earns $551.25 on $11,025 (total: $11,576.25).
• The principal grows exponentially due to compound interest.

Importance of Compound Interest

• Most personal finance experts emphasize the significance of compound interest in growing wealth, especially for retirement savings.

Further Learning

• For more information on interest rates, retirement, and personal finance, visit Wall Street Survivor.