How does interest work?

When we mention the word interest, it means a certain remuneration, which is usually charged to clients by banks (or other financial entities), according to the amount of money that was lent to them. The interest rate that is charged depends not only on the risk associated to the return of the loan but also on the administrative expenses and on the expected inflation.

What is the interest rate?

The interest rate is expressed in a percentage and it is used to calculate the value that the client will have to pay to the entity that lent him/her the money. For instance, if we borrow 2500 Euros from the bank and the bank charges us 10% a year, it means that in a year, when we give the money back to the bank, we will have to give back the bank that same amount plus 10%, this is, `2500 xx 0.10 = 250, 2500 + 250 = 2750`. The amount of 250 Euros corresponds to the charged interest and it is the profit of the bank.

There are different kinds of interest such as:

• Compound interest: it is the interest that is paid both on the original amount of money and on the interest that has been added to it. So, as to know more about this subject, have a look at the page about Compound Interest.
• Interest on arrears: it is also known as late interest and it means the money that someone owes that they not paid at the right time.
• Nominal interest: it includes the monetary correction of the borrowed value. In general, the offered rates included in the main financial methods of payment are expressed in nominal terms, that is, without deducing the inflation in the period.
• Simple interest: unlike the compound interest, this one is paid only on the original amount of the borrowed money and not on any interest.

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