When you get a loan from a bank, the bank will ask you to pay back more money than you borrowed. This extra money is called “interest.” The bank uses money from interest payments to pay their employees and pay for other items needed to keep the bank running. Interest is calculated by adding an agreed upon annual percentage rate to the loan balance. As the borrower makes their payment each month, a portion of the money pays the interest, and the rest is subtracted from the loan balance. This process is repeated each month until the loan is paid off.
In addition to interest, some loans may require the borrower to offer an item of value as “collateral” if they are unable to pay the loan back. For example, if your parents use a loan to buy a car, the car is the collateral on the loan. If they cannot make the payments on the loan, the car will be given back to the bank. The bank will then sell the car in order to pay off the remaining loan amount.
Interest – Annual percentage rate added to a loan balance.
Collateral – An item of value that can be collected if the borrower cannot make their payments.