Also, a fee paid for the use of loaned money. Interest is usually expressed as a percentage of the principal, the amount loaned. There are two types of interest: simple interest, where interest is paid only on the original principal amount, and compound interest, where interest is also paid on interest earned. As far as money-lending goes, simple interest is very seldom used - most lenders use the much more profitable technique of interest calculation that is compound interest. The fixed income markets (bonds, debentures, etc.) are based around financial instruments that pay regular interest.

The problem with a system that uses interest in this manner is that it creates poverty.

If money attracts more money, then that money must come from somewhere and debts increase as a consequence, so those who have money will lend it to those who don't, sure in the knowledge that they will be better off. This effectively means that rich people get richer, and poor people get much poorer quicker.

To those who would say that the entire economy rests on the principle of interest, I would point out that it is perfectly possible to run healthy banking systems without interest. Simply look to Arabic countries for numerous examples of this. Also note that as the basic rate of interest in the country increases, the economy slows down, whereas when it drops the economy warms up. This is because the economic system does not reach a homeostatic norm as it would do in a normal economy. There is always an imbalance caused by the rapid distribution of cash up the scale to rich people instead of evenly throughout the system.

The arbitrary control carried out by the central bank or legislative body reflects a poor understanding of the economic system's impact on an evolving country. The economy is a representation of the life energy of the country, it should be allowed to flow freely to areas where it is most needed and irrigate poor communities and businesses, instead of being sent whirling down a plug hole to the richest people, who need it least.

When I lend my neighbour 100 pounds, I want 100 back. I don't want 200 back or any other number. This is right, it is intuitive. If I am really poor, and need money to feed my children while I look for a job, and I borrow say 30 pounds, why, when I have to pay up should I pay 40 or more pounds? Or even a penny above what I lent? Am I the only one in the world who sees this as wrong? It means the loaner is richer than he was at the start, and I am worse off, unless I get a lucky break.

There is no justice in this.

Money collects in a big pool with rich people, and debts collect in a big pool with the poor people. To see an example of this in global terms, just look at African countries. They often have to spend upwards of 80% of GDP just to pay back the INTEREST ALONE of loans that were taken out decades ago. This means that there isn't enough money left for food, imports, education, or health or social benefits. This obviously makes the country weaker, and poorer and less likely to be able to pay. Meaning more interest, until finally the whole state is crippled. The jubilee project realised the fundamental injustice of this, and tried to forgive those debts. But they are just a symptom of a problem that affects all of us.

When I go to the bank and ask for a loan, the thing I am most worried about is the interest, and how much I have to pay back. If the project I am borrowing money for is worthy, why should I have to pay more than I borrow? If for example it is personal, then why not pay an upfront fee, with penalties for late payment instead of the torture of interest? That way at least I know there is a cap to how much I have to pay back should things go badly wrong.

What about return on investment, you say? If the project is good, and I pay the money back, the bank could ask for the right to buy a share of the business as it is lending the cash. Not too much, but it would ensure that there is benefit all around. There are many alternatives to interest, many of which don't have the potential pitfalls of an ever deepening hole that you have to climb out of in the current system. I would think again.

Debt is a bad thing, and I personally intend never to borrow any money from the bank at all. Ever. It's just not worth it.

Jaez: this is just not how it works, economically or sociopolitically. Several points:

1) The time value of money.

This is the fundamental principle of economics, the Peano's axiom of finance if you will, which says that it is worth more to have money today than the same amount of money at a future time. There are many reasons for this, principally that money can be turned into more money (invested), and that in a healthy economy money tends to become less valuable if you leave it sitting around stuffed in a mattress (this is called "inflation"). Even more fundamentally, there is utility in having money in the present: it can be turned into food, clothing, shelter, entertainment, or other nifty things. If you do not believe in the time value of money, for example, you should be willing to forgo your salary over the next 30 years and receive it all instead in a lump sum in 2031.

You are probably not willing to do that, because you will be getting hungry before then.

Whatever the reason to a specific lender and borrower, though, money has time value, and like anything else that has value the only way we know of to control supply and demand is with price systems, hence the interest rate is born.

2) "It means the loaner is richer than he was at the start"

Not necessarily. The lender is nominally richer, but can in fact be poorer in real terms. Let me explain how lending and borrowing works.

Lending is based on three factors:

  • Rate of return: The risk-free rate is a theoretical interest rate paid by a borrower with no probability of default ('default' = not paying the loan back, for whatever reason.) There is no such thing, of course, but the closest benchmark in the financial markets are U.S. government T-Bills and Treasury Bonds. For many purposes, you can think of the risk-free rate interchangably with the time value of money, ie: if the risk-free rate is 4% annually then $100 today is worth $104 a year from now, or (and this is the important part) receiving $100 a year from now is worth $100/$104 = $96.15 today. (This is called discounting). It's worth that *because* the opportunity cost of lending it is that high: if you held onto it and bought a T-Bill, you'd have that much later at essentially no risk. The risk-free rate tends to be low, which explains why the rate of return on things like T-Bills is so low in comparison to other instruments.

    The risk-free rate has to be considered together with the inflation rate, though, since while your money is busy being turned into more money it is also losing buying power. So if money is invested at the risk-free rate at 4% but the inflation rate is 5%, that money is deflating at 1% per annum. So part of what you're charging for when you charge interest on a loan is compensation for getting back the deflated principal at some future time: If I lend you $20 to refuel your car and by the time you pay me back it costs $30/tank, then I'm out $10.

  • Credit risk: All of the above is basically it if you are lending to a super-stable entity like a (well-established, politically and financially stable) government. But what if you are lending to a small business, or to a 25-year-old buying a sports car, or to an internet startup? Some of those loans are going to be riskier than others. A $100,000 loan to someone who goes bankrupt and does not pay you back is worth $0. Thus the value of the loan should actually be multiplied by (1 - p), where p is the probabilty of default. The rate of interest above the risk-free rate is compensation for taking on the risk of losing the whole loan. If you're a lending institution like Fannie Mae you have armies of statisticians that estimate these things for you, and you have a large enough portfolio that it behaves like those statistics, so you can not lose your shirt (this is called a "portfolio effect").
  • Liquidity: This is in some sense back to the time value of money. Liquidity measures how quickly and easily something (like a loan, or a bond, or a stock) can be turned back into cash. Most loans are not very liquid: As a lender I can't realistically show up at the door of the nice 26-year-old couple that borrowed $300,000 last year to buy a 3-bedroom house and ask for my money back. I can under certain circumstances sell their loan to someone else, however. The less liquid the loan, the higher the interest rate (since lenders on the balance prefer loans they can turn back into cash) that gets charged.1

All these things figure into how much a lender could realistically charge for a loan and hope to break even. The real 'usury' of the loan, the interest rate charged above and beyond all of this simply for the privilege of borrowing, is called a 'spread' and is usually quite small. Part of what makes it small is that there are efficient markets where lenders have to compete.

3) Upfront fees:

If the project I am borrowing money for is worthy, why should I have to pay more than I borrow? If for example it is personal, then why not pay an upfront fee, with penalties for late payment instead of the torture of interest? That way at least I know there is a cap to how much I have to pay back should things go badly wrong.

First of all this exists: it is called a zero-coupon loan. It exists most often in the bond markets (where it is just called a "zero"). If you think about it a second, an appropriately-sized upfront fee can be made equivalent to n-annual interest payments over a given time period. Example: if the risk-free rate is r, then a 5% annual loan on $10,000 over 2 years would have payments of $500 over the next two years. But the present value P of those two payments is P = 500/(1+r) + 500/(1+r)2. Any lender that can earn money at the rate r with no risk should be indifferent between charging a given interest rate and an upfront payment of all of the future payments discounted at the risk-free rate. It turns out, however, that most people prefer to spread out the payments because that's why they're borrowing in the first place. But this does exist in a hybrid form: when mortgage buyers pay 'points' to reduce their interest rate, this is exactly what is going on.

4) Justice to the borrower:

Borrowers benefit greatly from loans: most people cannot afford to buy a home, go to university (in the U.S. anyway) or even buy a car without a loan. Creating efficient markets in these is a win-win situtation: the lenders win by making a small profit on their loans. (If they're good at it: you don't have to look hard to find banks with an excess lot of loss-making loans on their books.) The borrowers win by having access to capital they would not otherwise have, and are willing to pay a premium for that access.

1Organizations like Fannie Mae and Sallie Mae make markets in things like mortgages and student loans in order to provide some liquidity, which ultimately reduces the cost to the buyers.
In today’s economy, inflation is inevitable. $10,000 today will not be worth $10,000 next year. Therefore, to keep the value of money the same, one is forced to find ways to invest his/her money to make more. One of the ways to do it is by lending someone the money, and then charging them interest. In the United States, the safest way to do that is by depositing the money in a bank. However, to make sure that one’s money are earning as much as possible, one must first know all the different types of interest offered and what they mean. Interest is broken down into two categories, simple interest and compound interest.

Simple Interest

This is the interest that is earned only on the initial amount. The formula for calculating simple interest is:
SI = P0(i)(n)
Where SI = simple interest in dollars
P0 = principal, or original amount borrowed (lent) at time period 0
i = interest rate per time period
n = number of time periods
To solve for the future value (also known as the terminal value) of the account at the end of n years (FVn), the following formula is used:
PVn = P0(1 + (i)(n))
To calculate the present value (the current value of money)(P0) the following formula is used:
P0 = FVn/(1 + (i)(n))

Compound Interest

This is the interest that is earned on the initial amount as well as any previous interest earned. This type of interest is most widely used. Because of its wide use, many forms of compound interest have been developed. The following are the most popular and widely used forms of compound interest.
Single Amounts
This compound interest is compounded every year. The formula used to find the future value of a compound interest is:
FVn = P0(1 + i)n
To find the present value, the following formula is used:
P0 = FVn(1/(1 + i)n)
Annuities
Annuities are series of equal payments or receipts (R) occurring over a specified number of periods (n). Assuming that one will deposit every annuity at a fixed interest rate (i) the following formula is used to find the future value of the annuity (FVAn):
R(((1 + i)n – 1)/i)
To find the present value of an annuity (PVAn) the following formula is used:
PVAn = R((1 – (1/(1 + i)n))/i)
Compounding More Than Once a Year
The general formula for solving for the future value at the end of n years where interest is paid m times a year is:
FVn = P0(1 + (i/m))mn
To find the present value of such compounding, the following formula is used:
P0 = FVn/(1 + (i/m))mn
Continuous Compounding
In this compounding, the interest is compounded continuously. The general formula for such compounding, where interest is compounded continuously at a rate of i percent at the end of n years is:
FVn = P0(e)in
The present value of this compounding is:
P0 = FVn/(e)in

These are the most common types of compounding used in the banks of United States.

Interest is essentially the cost of money, expressed as a percentage of the original amount of money, or "principal". There are several types of interest, as DWarrior explains above. The history of interest is a long one; interest rates sprung up almost as soon as the currency system was formed. Almost immediately, interest got a bad name. In Greece, Solon banned the practice of forcing men who couldn't pay back their loans into slavery. Religious groups, such as Islam and Christianity, called interest usury and declared it a sin. However, wealthy merchants ignored the laws on usury, and increased their own fortunes. Eventually, interest became divided into low rates, which were acceptable, and high rates, which still was categorized as the sin of usury. In 1545, England legalized interest, but set a maximum rate that could be charge. Other countries soon followed suit.

There have been many theories about interest througout history. The Classical Theory of Interest, which was formulated by Adam Smith and David Ricardo, stated that interest was the primary component balancing savings with investment. Marx, on the other hand, believed that interest was not natural in the economy, but was instead a means the capitalists used to exploit the working classes.

The Abstinence Theory, which was formulated by Nassau Senior, presented interest as a reward for placing money in a bank instead of spending it on goods. The more a person saved, the more money they got back, and the interest rates played the primary role in whether people saved or spent. An economist named Irving Fisher used the Abstinence Theory as a foundation for his Advanced Productivity theory, in which Fisher studied how willing people were to trade present income for a potentially larger future income.

However, the most famous economic theory regarding interest was concieved by John Maynard Keynes. Keynes believed that interest rates were a reward for giving up liquidity, and that interest rates were the prime reason to invest. This model is the basis for fluctuating interest rates.

Nowadays, interest theory revolves around the problem of inflation. In the United States, it is the responsibility of each state to set the maximum rate allowed in contracts. Because of this, in 1981, the state legislatures were all able to either increase or remove the maximum interest rates to benefit corporations that lent money. In Great Britain, the government does not set a maximum cap on interest rates, but the judicial system can declare individual rates under certain circumstances to be too high.

When interest rates go too high, then businesses and consumers are unable to take out loans. This hinders the economy. The worst example of this was in 1981, where the lowest interest rates were usually 20%. Most economists disagree on what caused these exceedingly high interest rates, but all agree that some important factors were the federal budget deficits, expectations of inflation, and the policies of the Federal Reserve System. In the late 1980's, interest rates began to drop again. After September 11th, interest rates plunged to a record low. However, since the United States' economy is still in the dumpster, it can be inferred that there is a medium somewhere for interest rates at which the economy will be most efficient.

In"ter*est (?), v. t. [imp. & p. p. Interested (?); p. pr. & vb. n. Interesting.] [From interess'd, p. p. of the older form interess, fr. F. int'eresser, L. interesse. See Interest, n.]

1.

To engage the attention of; to awaken interest in; to excite emotion or passion in, in behalf of a person or thing; as, the subject did not interest him; to interest one in charitable work.

To love our native country . . . to be interested in its concerns is natural to all men. Dryden.

A goddess who used to interest herself in marriages. Addison.

2.

To be concerned with or engaged in; to affect; to concern; to excite; -- often used impersonally.

[Obs.]

Or rather, gracious sir, Create me to this glory, since my cause Doth interest this fair quarrel. Ford.

3.

To cause or permit to share.

[Obs.]

The mystical communion of all faithful men is such as maketh every one to be interested in those precious blessings which any one of them receiveth at God's hands. Hooker.

Syn. -- To concern; excite; attract; entertain; engage; occupy; hold.

 

© Webster 1913.


In"ter*est, n. [OF. interest, F. int'eret, fr. L. interest it interests, is of interest, fr. interesse to be between, to be difference, to be importance; inter between + esse to be; cf. LL. interesse usury. See Essence.]

1.

Excitement of feeling, whether pleasant or painful, accompanying special attention to some object; concern.

Interest expresses mental excitement of various kinds and degrees. It may be intellectual, or sympathetic and emotional, or merely personal; as, an interest in philosophical research; an interest in human suffering; the interest which an avaricious man takes in money getting.

So much interest have I in thy sorrow. Shak.

2.

Participation in advantage, profit, and responsibility; share; portion; part; as, an interest in a brewery; he has parted with his interest in the stocks.

3.

Advantage, personal or general; good, regarded as a selfish benefit; profit; benefit.

Divisions hinder the common interest and public good. Sir W. Temple.

When interest calls of all her sneaking train. Pope.

4.

Premium paid for the use of money, -- usually reckoned as a percentage; as, interest at five per cent per annum on ten thousand dollars.

They have told their money, and let out Their coin upon large interest. Shak.

5.

Any excess of advantage over and above an exact equivalent for what is given or rendered.

You shall have your desires with interest. Shak.

6.

The persons interested in any particular business or measure, taken collectively; as, the iron interest; the cotton interest.

Compound interest, interest, not only on the original principal, but also on unpaid interest from the time it fell due. -- Simple interest, interest on the principal sum without interest on overdue interest.

 

© Webster 1913.

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