“Caution: borrowing money costs money!” You might recognise this line from credit provider ads. It’s true, borrowing money is not free: you pay interest on it (sometimes in addition to other costs). Read on to learn more about interest and how it can affect you

Why interest exists

Say you lend money to a friend. Of course you’re expecting this person to repay you at some point. Nonetheless, as with any lending, you’re aware there’s a chance you won’t see that money again. Your friend could make excuses, go bankrupt, or disappear, never to be heard from again.

Interest payments exist to compensate you for this risk and are paid on top of the amount you've lent. Interest is a cost for the borrower, while for the lender it’s payment for the risk they’ve agreed to take. 

Fixed and variable interest

Interest can be fixed or variable. With a fixed interest rate, the percentage stays the same for a longer period of time. On the other hand a variable interest rate is tied to a benchmark (i.e. euro money market benchmark Euribor) and its percentage can go up or down over time based on market conditions.

How interest rates are determined

What determines how high or low an interest rate is? Broadly speaking, three factors are taken into account.

• How high is the risk that the borrower will not be able to repay the loan?
  The higher the risk, the higher the interest rate.

• What other costs does the lender have?
  Lenders may include their costs in the interest rate.

• How much profit does the lender want to make on the loan?
  This is called the profit margin.

Different types of interest

In lesson 1.1.4, you learned about the central bank’s policy rate. But interest comes in many forms. Below, we discuss a few common types of interest you may personally encounter: savings interest, mortgage interest and interest on student loans.

Savings interest

Storing some money in a savings account? Your bank uses this money for various things, including loans to others. In return, the bank pays you savings interest. This is how you earn a small amount on your savings over time.

The savings interest rate changes from time to time. It can even become negative, meaning you don’t earn interest but actually have to pay for holding savings. Fortunately, this is rare. When the savings rate changes, your bank will announce this in advance.

Mortgage interest

Most people don’t have the money to buy a house, so they take out a mortgage. This is a loan used to pay for property. The house itself acts as collateral, which means that the lender, usually a bank, is allowed to sell the property if the borrower can’t repay the loan. The proceeds of this sale will then go to the lender.

A mortgage is repaid in installments, usually with a monthly payment. This payment consists of principal and interest. As you’ve probably guessed, the principal reduces the original loan, while the interest is the extra amount you pay as compensation for borrowing the money.

Interest on a student loan

Did you take out a loan to finance your studies? Then you not only have to repay this loan to the student finance authority, you also pay interest. In the Netherlands, the interest rate is usually between 2% and 4%, although it has been 0% in the past.

In most cases, you don’t have to start repaying a student loan immediately. In the Netherlands, you get two years after graduating to find a job and get your finances in order. When this time has elapsed, you begin repaying the loan over a period of many years, at the interest rate that applies at that time. This rate is set annually.

Takeaways

• Interest is the cost of borrowing money.

• Interest compensates the lender for risk and time.

• Interest is always a percentage of the borrowed amount

• Interest rates are determined by the level of the default risk by the borrower, costs incurred by the lender and a profit margin.