Interest

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Definition of Interest:

Interest is compensation for providing financial capital.

Detailed Explanation:

Interest is what is paid for providing the borrower with money (capital). The amount of interest paid depends on the interest rate. 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

When interest is paid, one party is making an investment, and the other party is compensating the investor for the use of the borrowed funds. For example, a business may want to expand its operations but lacks the capital it needs. It goes to the bank seeking a loan. The company agrees to pay the bank 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 money. The bank will then use the money to lend. Similarly, when an investor purchases a government bond he is lending the government money. In return, the government pays back the principal plus interest for the use of his money. In each of these cases, interest is compensation to an investor for providing money.

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.

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