What is interest?

Before I get into what interest is, let's first talk about a store and how it operates. Let's say we talk about a grocery store. It goes out and buys food at one price and turns around and sells the food to you and I at a higher amount in order to make a profit.

Banks are businesses and they want to make a profit too. How do they do that?

A bank makes money by making loans. If someone wants to buy a car, the bank will loan them the money. If a business wants to make a big purchase and they don't have the cash on hand, they can get a loan from the bank.

A loan from a bank works like this: you want a car but don't have the money to buy it. You go to the bank and ask for a loan. They give you the money and you promise to give it back to them over time.

But! You need to pay the bank for borrowing the money. Sometimes you'll pay upfront (there are many names for it, but is often called loan fees) but far more often you'll pay the bank a little at a time as you give them back their money. This is interest.

For instance, if you borrow $12000 and will make 12 monthly payments back to the bank, you'll pay $1000 each month as a payment to the bank. However, you'll also pay a little more, and this will be the interest (let's just say the loan charges $100 interest each month). And so you end up paying $1100 each month: $1000 to return the money (called the Principal Payment) and $100 as your cost of borrowing the money in the first place (the Interest).

Ok - so the bank loans money out to people and businesses who need it and they make money by doing so. But where does that money come from?

Imagine you want to open a new business and you want it to be a grocery store. One of the first things you'll need to do is go out and buy food in order to stock the shelves and have it ready for sale to customers. This same need exists for a bank - it needs to have cash to give to customers to borrow. Where does it come from?

One source is bank deposits. When I put money into the bank, they pay me a little interest. Why? In one sense, they are doing me a favour by holding my money - it's safer in the bank than under my mattress, they send me bank statements telling me how much I have, they pay salaries to employees, they pay rent and electric and all those other costs. Why in the world would they pay me to keep my money safe?

Because the bank wants to encourage you and I to keep our money in the bank so they can use it to loan it out. And so they pay us a little each month, interest, for the use of our money so they can loan it out and earn more money.

In fact, banks will offer more interest to us if we commit to keeping our money in the bank for longer periods of time - things like Certificates of Deposit pay higher amounts of interest but we can't access our money for months or even years at a time.

This is a video that has way more about banking: