What is interest?

Interest is the payment that lenders receive in exchange for allowing borrowers the use of some of their capital. It is a compensation for the lender having to forgo consumption at the present moment. It is a component of almost all commercial loans, and in repaying the debt, the borrower must pay the interest alongside the amount they originally borrowed, which is known as the principal. If someone borrows $1,000, and the interest rate is 5%, then they will owe $1,050 in total - the original $1,000 plus the additional $50 interest.

Without interest, there would be no reason for lenders to loan their funds - which entails forgoing the opportunity to spend their money - and savers would have no incentive to save.

The interest rate for a loan is expressed in terms of the percentage of the principal that is to be additionally repaid per year. Expressing an interest rate as a 'percent per annum' means that there is a common denominator for comparing loans. The interest rates on different types of loan or between countries that use different currencies (eg. dollar, euro, yen etc.) can be compared on the same terms.

What is the point of interest?

For the lender:
● Inflation – Interest covers the deficit between the price of goods and services when capital was loaned and the price when the debt is repaid. Due to inflation, the dollars loaned by the lender have less purchasing power when repaid than when they were lent – interest compensates for this loss.
● Risk – There are always risks for the lender inherent in the loan of capital. Firstly, it is impossible to determine the level of inflation that will occur between the loan and the repayment. Additionally, there is the risk that the borrower will not adhere to the terms of the loan. They may repay the loan late, or fail to pay it in full, or indeed at all. Interest serves as a security for this risk.
● Overheads – For financial institutions, the interest on a loan covers the operating costs of a loan, and supplies the profit that is necessary for a lender to continue to provide the service it does.

For the borrower:
● Paying interest on a loan is the trade-off borrowers make in exchange for the ability to purchase now rather than later, especially consumer goods.
● Loans also allow borrowers to make large payments on purchases, such as houses or cars, that they do not have sufficient capital of their own to pay for. Borrowers can then use their income to pay back a large lump sum in increments. Interest is again the trade-off for this benefit.
● In order to increase their future earning capacity, borrowers are willing to pay interest on loans that allow them to cover the costs of education.
● In order to invest in equipment, technology and infrastructure that will increase profits, businesses are willing to pay interest on loans that cover these outlays.
● Financial institutions pay interest to customers who deposit money with them because they can use the capital, either for investment or for their own lending purposes, to generate more revenue than they pay in interest, and therefore increase their profits.
● Some loans accrue tax advantages that compensate for the interest the borrower pays on the loan. For instance, mortgage interest is tax deductible.

Interest as expense and income

For those who are willing and able to forgo the use of their capital temporarily, interest is income. For instance, if you deposit your money into a bank account, or if you purchase Government Treasury Bonds, you receive interest as income.

For those who borrow money, whether as a mortgage on a house, or a business that takes out a loan in order to invest in new technology, interest is an added expense. Interest can also be used punitively, such as when credit card companies apply it to those who fail to repay their entire debt at the end of the month.

Interest rates direct capital to the areas where it can generate the greatest profit or to where loans are the most beneficial given the wider economic circumstances.

In economics, the term 'opportunity cost' is used to refer to what a person forgoes when they choose a certain course of action. When someone holds on to capital instead of saving or investing, the opportunity cost of this decision is measured by the interest rate, which they have forgone as a result. As such, interest is a way of measuring the cost of holding on to money.