What is Interest?

Interest is the compensation you pay or receive for borrowing or lending money. When you deposit money into a savings account, you earn interest from the bank because, in effect, you are lending money to the bank. Conversely, you pay interest when you borrow money for a car, education, or other purposes. You can think of interest as the “price of money.”

Investments can also involve interest. For example, if you invest in bonds, you receive a fixed or variable interest payment. Often, in investments, the higher the interest rate, the greater the risk. Higher returns compensate for the increased chance that a company or government (the bond issuer) might not meet its payment obligations.

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How Does Interest on a Loan Work?

When you borrow money, you typically enter into a credit agreement with a bank or other lender. This agreement specifies:

• The borrowed amount (principal)
• The loan term (how long it will take to repay)
• The interest rate
• The repayment structure (linear, annuity, or other)

Interest is calculated based on the outstanding amount (the principal). If you repay part of the loan every month, the principal decreases, which also lowers the interest amount you pay monthly.
With consumer loans—such as revolving credit or personal loans—the interest rate is generally higher than with a mortgage. This is because the lender takes on more risk since the borrowed money is not secured by collateral (like a house).

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Different Types of Loan Interest

• Fixed Interest – You agree on a fixed interest rate for the entire loan term , making your costs predictable.
• Variable Interest – The interest rate can change during the loan term. This can be beneficial if interest rates fall, but less favorable if they rise.
• Credit Card Interest – For purchases that you don not repay immediately, you typically pay higher interest rates than with other types of loans.
• Store or Online Store Credit – Some retailers offer the option to pay afterward or in installments. Be aware that these interest rates can be higher than expected.

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How Does Mortgage Interest Work?

When you take out a mortgage to buy a house, the house serves as collateral. This reduces the risk for the bank, which often results in a lower interest rate compared to consumer loans.
You can choose a fixed interest rate, which guarantees stable monthly payments during the fixed-rate period (e.g., 10 or 20 years). A variable interest rate, on the other hand, can change based on market conditions. If rates drop, your payments decrease; if rates rise, you will pay more.

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Variable Interest and Frequency of Interest Payments

Variable interest rates can be adjusted by the bank monthly, quarterly, or semi-annually. The frequency of these adjustments depends on the loan agreement or product.
The same applies for savings accounts; interest rates can change monthly or annually. Similarly, some banks pay out interest monthly, while others pay quarterly or annually. This affects the amount you ultimately receive or pay, since more frequent payments create a compound interest effect.

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Compound Interest

Compound interest, also known as "interest on interest," is an important concept for long-term saving or borrowing. For example, if you receive interest on your savings, that interest will generate additional interest in future periods.
The same applies to loans: if you do not repay on time, interest is added to your outstanding debt, increasing your total debt faster. The effect of compound interest can be significant, especially over long periods.

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Nominal vs. Effective Interest

Nominal interest is the interest rate advertised by a bank or lender. Effective interest takes into account the payment frequency.  If interest is credited or calculated monthly, savers benefit from the compound interest effect, making the effective interest rate higher than the nominal rate. Conversely, for loans, the effective interest rate can be higher than the nominal rate if interest is calculated more frequently. Therefore, it is essential to pay attention to the effective interest rate to know the true amount you will pay or receive.

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Factors That Determine Interest Rates

Several factors influence the level of interest rates:

• Supply and Demand – High demand for loans can increase interest rates, while abundant savings and lower demand can lower rates
• Central Bank Policy – The European Central Bank (ECB) sets policy rates. Changes in these rates directly impact the interest rates banks offer their customers.
• Inflation – Low inflation in recent years has been accompanied by very low interest rates. When inflation rises, interest rates usually increase as well.
• Risk and Duration – The longer the loan term and the higher the risk, the higher the interest rate.

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Grassfeld: Your Financial Partner

Interest plays a major role in your financial life. To keep track of your financial situation and maintain control over your income and expenses, you can use the free Grassfeld app.
By linking your bank account, transactions are automatically categorized, giving you a clear overview of your finances. You can also create budgets and set savings goals through the app. Grassfeld helps you stay financially healthy.