What is an Interest Cost?

The interest cost is the amount of money an individual or corporation pays for the privilege of borrowing money. In nearly every loan transaction, some degree of interest is charged when the lender gives the borrower the use of funds. The interest cost, which is calculated in a number of different ways, makes the loan attractive to lenders who are able to make money off of allowing the borrower the use of their funds.

Many people and corporations throughout the world borrow money to buy homes, cars, buildings, and other goods. Governments, as well, borrow money from companies and private individuals to keep the government running. In all of these situations, the individual borrowing the money is taking on debt, and has to pay interest for that debt.

Interest may be charged on a monthly basis, a daily basis or an annual basis, depending on the terms of the loan. The interest cost is usually stated in terms of the APR, which stands for annual percentage rate. Interest is described by the APR even in situations where interest is charged more regularly than on an annual basis. For example, if an individual takes on a mortgage, his or her interest rate might be 5 percent. This 5 percent refers to the annual interest charged on her loan though she still must pay interest on a monthly basis.

The amount of interest an individual pays is equal to the amount of money borrowed (the principal) times the interest cost. For example, if a person borrowed $500,000 US Dollars (USD) for his mortgage at 5 percent interest, he would be paying an interest cost of $25,000 USD per year. To calculate the interest exactly, however, he would need to multiply his principal owed each month times the monthly interest, since his principal would be decreasing as he made payments, although his interest rate would remain the same.

The interest rate an individual is charged, which determines the total cost, is generally based on his credit score. In the United States, this score is also called a Fair Isaac and Company Score (FICO score) and is a score provided by the three major credit bureaus: Equifax, Experian and TransUnion. A higher credit score will lead to a lower interest cost, while a lower credit score will lead to a higher cost.