Interest is in the terms and conditions of personal loans, credit cards, mortgages and other financial products. Here we let you in on what it’s all about.

Interest tells us the cost of borrowing money from banks and the yield of our savings and investments. It’s the price charged for borrowing capital.

An interest rate is a percentage that the borrower agrees to pay for a loan during its term. For instance, if we take out a one-year, EUR 1,000 loan at an interest rate of 5%, the loan will cost us EUR 50. The total amount we'll repay is EUR 1,050. As we’ll see below, there are several types of interest.

What is interest for?

Bank financing can be in the form of a loan or line of credit. Alternatively, if we want our money to yield a return, we can use investment funds, savings plans, remunerated accounts and other products.

Whether we’re the lender (creditor) or borrower (debtor), it’s vital we know how interest works. Three reasons for charging interest are:

• Payment. Since the lender is out of pocket during the loan term, interest compensates them for the temporary shortfall.
• Depreciation. Inflation and other circumstances can cause the value of money to drop. Thus, interest offsets the lender’s potential loss of purchasing power during the loan term.
• Risk assumption. Interest can serve as an incentive to invest. Broadly speaking, investing entails risks due to the uncertainty of returns: the greater the risk, the higher the interest.

Types of interest

Central banks (such as the European Central Bank in the EU) typically set interest rate benchmarks. However, banks are free to set their own rates based on supply and demand.

The types of interest we find in financial products are:

• Fixed. Agreed by the parties at the outset, it remains the same throughout the loan term, irrespective of market behaviour.
• Variable. It changes during the loan term based on market behaviour. It takes into account benchmark rates such as the Euribor, which indicates how much a panel of European banks charge for borrowing funds from one another. It’s usually used with long-term loans.
• Mixed. It combines fixed and variable rates. Interest will be fixed in the early stages of the term and later change to a variable rate up to maturity.
• Compound. Accrued interest (typically in a year) is added to the principal to calculate a new rate for the next period. For instance, if we lend EUR 1,000 at an annual interest rate of 10%, we’ll earn EUR 100 at the end of the first year. The interest for the following year will be reckoned on EUR 1,100.
• Simple. The rate is calculated on the principal without interest from previous periods. Thus, the total is always the same.

How much do you know about interest? Find out by taking this quiz (in Spanish) from Santander Consumer España’s blog, Tu Futuro Próximo (“Your near future”).

Why must we pay interest?

Now we know what interest is and how it’s calculated, we must also learn about fulfilling financial obligations. While interest from savings and investments gives us a return, we also have to pay it on what we borrow.

“Default” or "late payment” interest is charged when a borrower fails to make due repayments. The rate is usually higher to discourage borrowers from paying late. Additional fees could also harm our financial health. Many countries have laws on this type of interest to ensure control. In Spain, the government budget sets a statutory interest rate as the basis for calculating late payment interest.