A Fee Paid on Borrowed Assets
Interest is a fee paid on borrowed assets. It is the price paid for the use of borrowed money, or, money earned by deposited funds. Assets that are sometimes lent with interest include money, shares, consumer goods through hire purchase, major assets such as aircraft, and even entire factories in finance lease arrangements. The interest is calculated upon the value of the assets in the same manner as upon money. Interest can be thought of as "rent of money". For example, if you want to borrow money from the bank, there is a certain rate you have to pay according to how much you want loaned to you.
Interest is compensation to the lender for forgoing other useful investments that could have been made with the loaned asset. These forgone investments are known as the opportunity cost. Instead of the lender using the assets directly, they are advanced to the borrower. The borrower then enjoys the benefit of using the assets ahead of the effort required to obtain them, while the lender enjoys the benefit of the fee paid by the borrower for the privilege. The amount lent, or the value of the assets lent, is called the principal. This principal value is held by the borrower on credit. Interest is therefore the price of credit, not the price of money as it is commonly believed to be. The percentage of the principal that is paid as a fee (the interest), over a certain period of time, is called the interest rate.
History of interest
Interest is the price paid for the use of savings over a given period of time.
In ancient biblical Israel, it was against the Law of Moses to charge interest
on private loans .During the Middle Ages, time was considered to be property of
God. Therefore, to charge interest was considered to be commerce with God's
property. Also, St. Thomas Aquinas, the leading theologian of the Catholic
Church, argued that the charging of interest is wrong because it amounts to
"double charging", charging for both the thing and the use of the thing. The
church regarded this as a sin of usury; nevertheless, this rule was never
strictly obeyed and eroded gradually until it disappeared during the industrial
revolution.
Usury has always been viewed negatively by the Roman Catholic Church. The Second
Lateran Council condemned any repayment of a debt with more money than was
originally loaned, the Council of Vienna explicitly prohibited usury and
declared any legislation tolerant of usury to be heretical, and the first
scholastics reproved the charging of interest. In the medieval economy, loans
were entirely a consequence of necessity (bad harvests, fire in a workplace)
and, under those conditions, it was considered morally reproachable to charge
interest.
Interest has often been looked down upon in Islamic civilization as well for the same reason for which usury was forbidden by the Catholic Church, with most scholars agreeing that the Qur'an explicitly forbids charging interest. Medieval jurists therefore developed several financial instruments to encourage responsible lending.
In the Renaissance era, greater mobility of people facilitated an increase in commerce and the appearance of appropriate conditions for entrepreneurs to start new, lucrative businesses. Given that borrowed money was no longer strictly for consumption but for production as well, interest was no longer viewed in the same manner. The School of Salamanca elaborated on various reasons that justified the charging of interest: the person who received a loan benefited, and one could consider interest as a premium paid for the risk taken by the loaning party. There was also the question of opportunity cost, in that the loaning party lost other possibilities of using the loaned money. Finally and perhaps most originally was the consideration of money itself as merchandise, and the use of one's money as something for which one should receive a benefit in the form of interest. Martín de Azpilcueta also considered the effect of time. Other things being equal, one would prefer to receive a given good now rather than in the future. This preference indicates greater value. Interest, under this theory, is the payment for the time the loaning individual is deprived of the money.
Economically, the interest rate is the cost of capital and is subject to the laws of supply and demand of the money supply. The first attempt to control interest rates through manipulation of the money supply was made by the French Central Bank in 1847.
The first formal studies of interest rates and their impact on society were conducted by Adam Smith, Jeremy Bentham and Mirabeau during the birth of classic economic thought.
In the early 20th century, Irving Fisher made a major breakthrough in the
economic analysis of interest rates by distinguishing nominal interest from real
interest. Several perspectives on the nature and impact of interest rates have
arisen since then. Among academics, the more modern views of John Maynard Keynes
and Milton Friedman are widely accepted.
The latter half of the 20th century saw the rise of interestfree Islamic banking and finance, a movement which attempts to apply religious law developed in the medieval period to the modern economy. Some entire countries, including Iran, Sudan, and Pakistan, have taken steps to eradicate interest from their financial systems entirely. Rather than charging interest, the interestfree lender charges a "fee" for the service of lending. As any such fee can be shown to be mathematically identical to an interest charge, the distinction between "interestfree" banking and "forinterest" banking is merely one of semantics.
Types of interest
Simple interest
Simple interest is calculated only on the principal amount, or on that portion of the principal amount which remains unpaid.
The amount of simple interest is calculated according to the following formula:
where r is the period interest rate (I/m), B0 the initial balance and m the number of time periods elapsed.
To calculate the period interest rate r, one divides the interest rate I by the number of periods m.
For example, imagine that a credit card holder has an outstanding balance of $2500 and that the simple interest rate is 12.99% per annum. The interest added at the end of 3 months would be,
and he would have to pay $2581.19 to pay off the balance at this point.
If instead he makes interestonly payments for each of those 3 months at the period rate r, the amount of interest paid would be,
His balance at the end of 3 months would still be $2500.
In this case, the time value of money is not factored in. The steady payments have an additional cost that needs to be considered when comparing loans. For example, given a $100 principal:
Credit card debt where $1/day is charged: 1/100 = 1%/day = 7%/week = 365%/year.
Corporate bond where the first $3 are due after six months, and the second $3 are due at the year's end: (3+3)/100 = 6%/year.
Certificate of deposit (GIC) where $6 is paid at the year's end: 6/100 = 6%/year.
There are two complications involved when comparing different simple interest bearing offers.
When rates are the same but the periods are different a direct comparison is inaccurate because of the time value of money. Paying $3 every six months costs more than $6 paid at year end so, the 6% bond cannot be 'equated' to the 6% GIC.
When interest is due, but not paid, does it remain 'interest payable', like the bond's $3 payment after six months or, will it be added to the balance due? In the latter case it is no longer simple interest, but compound interest.
A bank account offering only simple interest and from which money can freely be withdrawn is unlikely, since withdrawing money and immediately depositing it again would be advantageous.
Compound interest
Main article: Compound interest
Compound interest is very similar to simple interest; however, with time, the difference becomes considerably larger. This difference is because unpaid interest is added to the balance due. Put another way, the borrower is charged interest on previous interest. Assuming that no part of the principal or subsequent interest has been paid, the debt is calculated by the following formulas:
where I comp is the compound interest, B0 the initial balance, Bn the balance after n periods (where n is not necessarily an integer) and r the period rate.
For example, if the credit card holder above chose not to make any payments, the interest would accumulate
So, at the end of 3 months the credit card holder's balance would be $2582.07 and he would now have to pay $82.07 to get it down to the initial balance. Simple interest is approximately the same as compound interest over short periods of time, so frequent payments are the best (least expensive) payment strategy.
A problem with compound interest is that the resulting obligation can be difficult to interpret. To simplify this problem, a common convention in economics is to disclose the interest rate as though the term were one year, with annual compounding, yielding the effective interest rate. However, interest rates in lending are often quoted as nominal interest rates (i.e., compounding interest uncorrected for the frequency of compounding).
Loans often include various noninterest charges and fees. One example are
points on a mortgage loan in the United States. When such fees are present,
lenders are regularly required to provide information on the 'true' cost of
finance, often expressed as an annual percentage rate (APR). The APR attempts to
express the total cost of a loan as an interest rate after including the
additional fees and expenses, although details may vary by jurisdiction. In
economics, continuous compounding is often used due to its particular
mathematical properties.
Fixed and floating rates
Commercial loans generally use simple interest, but they may not always have a
single interest rate over the life of the loan. Loans for which the interest
rate does not change are referred to as fixed rate loans. Loans may also have a
changeable rate over the life of the loan based on some reference rate (such as
LIBOR and EURIBOR), usually plus (or minus) a fixed margin. These are known as
floating rate, variable rate or adjustable rate loans. Combinations of
fixedrate and floatingrate loans are possible and frequently used. Loans may
also have different interest rates applied over the life of the loan, where the
changes to the interest rate are governed by specific criteria other than an
underlying interest rate. An example would be a loan that uses specific periods
of time to dictate specific changes in the rate, such as a rate of 5% in the
first year, 6% in the second, and 7% in the third.
Composition of interest rates
i = r + π
Where i is the nominal interest, r is the real interest and π is inflation.
This formula attempts to measure the value of the interest in units of stable purchasing power. However, if this statement was true, it would imply at least two misconceptions. First, that all interest rates within an area that shares the same inflation (i.e. the same country) should be the same. Second, that the lender knows the inflation for the period of time that he/she is going to lend the money.
One reason behind the difference between the interest that yields a Treasury bond and the interest that yields a Mortgage loan is the risk that the lender takes from lending money to an economic agent. In this particular case, a government is more likely to pay than a private citizen. Therefore, the interest rate charged to a private citizen is larger than the rate charged to the government.
To take into account the information asymmetry aforementioned, both the value of inflation and the real price of money is changed to their expected values resulting in the following equation:
it = r(t + 1) + π(t + 1) + σ
Where it is the nominal interest at the time of the loan, r(t + 1) is the real interest expected over the period of the loan, π(t + 1) is the inflation expected over the period of the loan and σ is the representative value for the risk engaged in the operation.
Cumulative interest or return
The calculation for cumulative interest is (FV/PV)1. It ignores the 'per year'
convention and assumes compounding at every payment date. It is usually used to
compare two long term opportunities.
Other conventions and uses
Exceptions:
US and Canadian TBills (short term Government debt) have a different calculation for interest. Their interest is calculated as (100P)/P where 'P' is the price paid. Instead of normalizing it to a year, the interest is prorated by the number of days 't': (365/t)*100. (See also: Day count convention). The total calculation is ((100P)/P)*((365/t)*100). This is equivalent to calculating the price by a process called discounting at a simple interest rate.
Corporate Bonds are most frequently payable twice yearly. The amount of interest paid is the simple interest disclosed divided by two (multiplied by the face value of debt).
Flat Rate Loans and the Rule of 78s: Some consumer loans have been structured as flat rate loans, with the loan outstanding determined by allocating the total interest across the term of the loan by using the "Rule of 78s" or "Sum of digits" method. Seventyeight is the sum of the numbers 1 through 12, inclusive. The practice enabled quick calculations of interest in the precomputer days. In a loan with interest calculated per the Rule of 78s, the total interest over the life of the loan is calculated as either simple or compound interest and amounts to the same as either of the above methods. Payments remain constant over the life of the loan; however, payments are allocated to interest in progressively smaller amounts. In a oneyear loan, in the first month, 12/78 of all interest owed over the life of the loan is due; in the second month, 11/78; progressing to the twelfth month where only 1/78 of all interest is due. The practical effect of the Rule of 78s is to make early payoffs of term loans more expensive. For a one year loan, approximately 3/4 of all interest due is collected by the sixth month, and payoff of the principal then will cause the effective interest rate to be much higher than the APY
used to calculate the payments.
In 1992, the United States outlawed the use of "Rule of 78s" interest in connection with mortgage refinancing and other consumer loans over five years in term. Certain other jurisdictions have outlawed application of the Rule of 78s in certain types of loans, particularly consumer loans.
Rule of 72: The "Rule of 72" is a "quick and dirty" method for finding out how fast money doubles for a given interest rate. For example, if you have an interest rate of 6%, it will take 72/6 or 12 years for your money to double, compounding at 6%. This is an approximation that starts to break down above 10%.
Market interest rates
There are markets for investments (which include the money market, bond market, as well as retail financial institutions like banks) set interest rates. Each specific debt takes into account the following factors in determining its interest rate:
Opportunity cost
This encompasses any other use to which the money could be put, including lending to others, investing elsewhere, holding cash (for safety, for example), and simply spending the funds.
Inflation
Since the lender is deferring his consumption, he will at a bare minimum, want to recover enough to pay the increased cost of goods due to inflation. Because future inflation is unknown, there are three tactics.
Charge X% interest 'plus inflation'. Many governments issue 'realreturn' or 'inflation indexed' bonds. The principal amount or the interest payments are continually increased by the rate of inflation. See the discussion at real interest rate.
Decide on the 'expected' inflation rate. This still leaves both parties exposed to the risk of 'unexpected' inflation.
Allow the interest rate to be periodically changed. While a 'fixed interest rate' remains the same throughout the life of the debt, 'variable' or 'floating' rates can be reset. There are derivative products that allow for hedging and swaps between the two.
Default
There is always the risk the borrower will become bankrupt, abscond or otherwise default on the loan. The risk premium attempts to measure the integrity of the borrower, the risk of his enterprise succeeding and the security of any collateral pledged. For example, loans to developing countries have higher risk premiums than those to the US government due to the difference in creditworthiness. An operating line of credit to a business will have a higher rate than a mortgage.
The creditworthiness of businesses is measured by bond rating services and individual's credit scores by credit bureaus. The risks of an individual debt may have a large standard deviation of possibilities. The lender may want to cover his maximum risk, but lenders with portfolios of debt can lower the risk premium to cover just the most probable outcome.
Deferred consumption
Charging interest equal only to inflation will leave the lender with the same purchasing power, but he would prefer his own consumption sooner rather than later. There will be an interest premium of the delay. He may not want to consume, but instead would invest in another product. The possible return he could realize in competing investments will determine what interest he charges.
Length of time
Shorter terms have less risk of default and inflation because the near future is easier to predict. Broadly speaking, if interest rates increase, then investment decreases due to the higher cost of borrowing (all else being equal).
Interest rates are generally determined by the market, but government intervention  usually by a central bank may strongly influence shortterm interest rates, and is used as the main tool of monetary policy. The central bank offers to buy or sell money at the desired rate and, due to their control of certain tools (such as, in many countries, the ability to print money) they are able to influence overall market interest rates.
Investment can change rapidly in response to changes in interest rates, affecting national income, and, through Okun's Law, changes in output affect unemployment.
Open market operations in the United States
The effective federal funds rate charted over fifty years.
The Federal Reserve (Fed) implements monetary policy largely by targeting the federal funds rate. This is the rate that banks charge each other for overnight loans of federal funds. Federal funds are the reserves held by banks at the Fed.
Open market operations are one tool within monetary policy implemented by the Federal Reserve to steer shortterm interest rates. Using the power to buy and sell treasury securities, the Open Market Desk at the Federal Reserve Bank of New York can supply the market with dollars by purchasing Tnotes, hence increasing the nation's money supply. By increasing the money supply or Aggregate Supply of Funding (ASF), interest rates will fall due to the excess of dollars banks will end up with in their reserves. Excess reserves may be lent in the Fed funds market to other banks, thus driving down rates.
Interest rates and credit risk
It is increasingly recognized that the business cycle, interest rates and credit risk are tightly interrelated. The JarrowTurnbull model was the first model of credit risk which explicitly had random interest rates at its core. Lando (2004), Darrell Duffie and Singleton (2003), and van Deventer and Imai (2003) discuss interest rates when the issuer of the interestbearing instrument can default.
Money and inflation
Loans, bonds, and shares have some of the characteristics of money and are
included in the broad money supply. By setting i*n, the government institution
can affect the markets to alter the total of loans, bonds and shares issued.
Generally speaking, a higher real interest rate reduces the broad money supply.
Through the quantity theory of money, increases in the money supply lead to
inflation. This means that interest rates can affect inflation in the future.
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