Interest is compensation to an investor for providing capital (money) to a borrower. The amount of interest depends on the interest rate and the amount borrowed. A company may want to expand its operations but lacks the capital it needs so it applies for a loan from a bank. It agrees to pay the bank back the money it borrowed plus interest within an agreed-upon period.
When money is deposited with a bank, the bank pays the depositor interest for the use of the funds. The bank will use the money to lend. Similarly, when an investor purchases a government bond, the investor is lending the government money. In return, the government pays back the principal plus interest for the use of the investor's money. In each of these cases, interest is an investor's compensation for providing capital.
Simple interest is calculated by multiplying the principal balance and the interest rate. Compounding refers to when interest can earn interest. For example, a family purchases a $30,000 certificate of deposit paying a four percent interest rate. In the first year, $1,200 interest is paid. In the second year, the certificate of deposit would earn $1,248 if the interest is compounded annually because the $1,200 earned in year one would earn interest in year two. Paying down the balance on a loan can save borrowers a lot of interest. For an eye-opening exercise on the benefits of compound interest, use NerdWallet's compound interest calculator.
Ownership interest refers to the amount an investor owns in a company. For example, if an investor owns 10 percent of a company’s outstanding common shares, the investor probably has a 10 percent ownership interest in the company. Here interest refers to the percentage of ownership resulting from making an investment in the company.
