Almost everybody has heard of interest, but why does it exist and should you avoid borrowing money just to avoid paying it?

Interest is essentially the charge that a borrower pays for the right to borrow money. It has tons of applications in personal finance including mortgages, credit cards, and car loans.

There are a couple of reasons that interest is charged. When someone lends money, that money is no longer dispensable for their own needs. Interest serves as compensation for this. Additionally, if a borrower defaults on a loan, the interest earned would lessen the total amount the lender lost, serving as a risk-management tool. Lastly, even if the borrower completes their payments, inflation reduces the value or purchasing power of the loan over time, which would mean lost money for the lender. By charging interest, a lender is hedging against inflation and loss. 

It may seem like the easiest way to go is to avoid borrowing money entirely. While this is true for some expenses, it is important to consider that investing your money might be more beneficial than spending a ton of it at once with the sole purpose of avoiding interest. If your rate of return from investment would be higher than the interest rate of financing something, it might be better to take out a loan for it. If you were buying a house, paying cash would mean tying up a lot of money in one investment, and since residential real estate typically doesn’t provide high returns, that isn’t ideal from a financial standpoint. On the other hand, financing it and investing your money would help you in the long run.