Interest is the compensation paid by a debtor to a creditor for the use of the creditor’s money. Over time, due to inflation, the value of money decreases. Interest on credit can be either simple or compound. Simple interest is interest charged only on the principal amount borrowed. Simple interest does not add the interest charge back to the outstanding loan during the length of the loan. Thus, simple interest charges are less than compound interest charges. Compound interest is interest charged not only on the principal, but on the interest accrued during the length of the loan. Compound interest is more expensive to the consumer because interest is charged on top of interest.
The amount of interest that can be charged is limited and regulated by state laws. The percentage interest rate allowed varies from state to state, depending on the type of credit being extended. A fixed interest rate does not change throughout the duration of the extension of credit. Under a variable rate loan, the finance charge is determined by an index, such as the “prime rate” published nationally each quarter for short-term loans charged by banks. This allows the lender to charge an interest rate that reflects current market conditions. Regardless of whether the interest rate charged is fixed or variable, the rate may not exceed the permissible rate set by state usury laws.