ELI5: What is interest and why do banks charge it?

Interest is like a fee you pay for borrowing something, or a reward you get for letting someone use your money.

Imagine you want to borrow your friend’s cool toy car. You promise to give it back, but your friend might say, "Okay, but you have to give me one of your candies each day you keep it." That candy is like interest. You're paying a little extra for the privilege of borrowing the toy.

Banks work similarly.

• Borrowing from the bank: When you borrow money from the bank (like taking out a loan to buy a house or a car), the bank lets you use their money. Since they're letting you use it, they charge you interest. It's like renting money! This interest is usually a percentage of the amount you borrowed, and you pay it back over time along with the original amount you borrowed (the principal).

• Saving with the bank: When you put your money in a savings account, you're letting the bank use your money. The bank uses your money (and other people's money) to make loans to other people. Because you're letting them use your money, they pay you interest as a reward. It's a little bit like the bank is renting your money.

• To make money: Banks are businesses, and they need to make a profit to stay open. Interest is how they make money.
• To cover their risks: Lending money is risky. Sometimes people don't pay back their loans. Interest helps the bank cover these potential losses.
• To account for inflation: Over time, things get more expensive. Interest helps the bank maintain the value of their money.