LeoGlossary: Interest
In finance and economics, interest is the money paid by borrowers to lenders for the use of money. It can be looked at as the cost for using money.
This is expressed as a percentage, which is called the interest rate. The term for the rate is usually on a yearly basis.
The total repayment on a loan is principal plus interest paid over the life of the transaction.
It is an idea that holds where referring to loans from financial institutions or through the debt market.
Borrowing Money
When an individual, company, or government needs money, it seeks to borrow it. This means receiving an amount known as the principal sum. There will be an interest rate tied to the payment. The total paid will exceed the principal (the original amount borrowed) by the interest paid.
Some examples of where interest in applied:
mortgages car loans credit cards HELOC line of credit business loans
The borrower is willing to pay the interest to gain access to the money.
Lending Money
Interest takes on a different meaning when looking at the equation from the lender's perspective.
When loaning money, interest ends up being the profit on the transaction. This will exclude any fees such as large charges or original fees.
Banks are the traditional entities that lends money. Over time, FinTech brought newer players into the market. Many people acquire loans through applications. These are often financed through the traditional banking system.
Credit card companies operate as lenders also. When one is able to carry a balance, interest is applied. This is the price the company puts on the time value of money.
Corporations have another area to turn when money is needed. The debt markets are where investors become lenders. When individuals buy fixed income instruments such as bonds, the coupon rate is the interest paid by the borrowing company to the investor.
Companies that carry greater risk are going to have to pay more a great interest rate.
Finally, governments are able to access the debt markets. They do not go into the open market like corporations. Sovereign debt is done through the central bank, who interacts with the primary dealers. These are major investment banks that sell the bonds and notes to their customers. Typically, those customer are hedge funds, insurance companies, bond investors, and pension funds.
It is important to note that interest and profit will differ from accounting perspectives. Interest is the money earned on loans whereas profit applies to investments on assets or operations for the enterprise.
Credit And Defaults
When banks make loans, they are extending credit. There are risks associated with lending. The ability to repay is considered by the institution before making the loan.
The amount of interest is often tied to the prospect of an individual or company repaying the loan. When the risk of default is greater, the interest rate is higher to compensate the lender for assuming the higher risk variable.
It is a practice that also applies to investors in the bond market. Companies with weaker financial statements will often have to pay a higher amount of interest on the same money as one that is more financially sound.
Since interest is the "profit" a lender earns on a loan, it is important the total exceeds the losses associated with defaults. A bank that is having its loans defaults exceed the total interest earned could find itself insolvent.
Regulators monitor how the loan portfolio of a bank is doing. If the bad debt ratio gets out of line, the bank will have to do a capital raise.
Banks can also hedge their positions by selling some of the loans, thus transferring the risk to investors willing to take it on. This results in the loan being sold to another party at a discount.
How Banks Make Money
Banks, specifically depository institutions, make money by borrowing at one interest rate and lending out at a higher rate. The "borrowing" comes in the form of deposits. People put their money in a bank, earning interest on their accounts. The bank, in turn, uses this money to make loans, which they charge a higher rate. This is why mortgages rates are higher than savings rates.
This ability gets leveraged through fractional reserve banking. Banks are required to keep a certain percentage of capital on here to "back" the deposits. Since not all depositors are going to make a withdrawal at the same time, banks are authorized to lend all the deposits beyond a certain point.
All money that is loaned out will carry a certain amount of interest that the bank earns.
Compound Interest
Read The Difference Between APR and APY
Compound interest is a wealth building strategy.
This is the concept of Annual Percentage Yield versus Annual Percentage Rate. The latter is a straight line return. For example, if we have $1,000 at 5%, this is $50 annually.
APY is the concept of earning interest on interest. The first payout is added to the balance and the interest rate is applied to that.
The idea is the money compounds over time, which created exponential growth.
Most are familiar with this idea regarding debt, most notably credit cards. It is why paying the monthly minimum doesn't reduce the total a outstanding a great deal. The unpaid amount keeps compounding, benefiting the card issuer.
History of Interest
While it is commonplace to pay interest on money borrowed, this was not always the case. It started to emerge during the the Renaissance.
Prior to that, it was frowned upon to charge interest on money lending. This was viewed as a sin since the ones borrowing were in need of cash. It was a part of the social norms from ancient Middle Eastern civilizations to Medieval times. The idea of taking advantaged of the impoverished pushed this concept for centuries, being considered usury.
Things started to change during the Renaissance when people started to take loans in an effort to grow businesses. The moral repudiation associated with lending diminished as markets started to thrive and economies expanded.
Money was also views as a commodity during this period, meaning that it was something to worth charging for.
In the 1700s and 1800s, political philosophers along with economic writers started to espouse the idea of charging interest on money. The view shifted to this becoming an important part of the economy.
Alternative Definition
It is also a right, share, or title in property or some other asset.
