Interest is the name for the cost of the privilege of being able to borrow money, or, in financial terms, to receive credit. It is paid to the provider of the loan, or creditor. ‘Interest’ may be so titled because it is the potential for profit which makes lending money of interest to the lender. Lending money is risky business – there is always the risk that the person lending may default on their debts. There needs to be some incentive for credit to circulate – after all, if there was no payment for taking the risk of lending, no-one would bother doing it. Thus, interest has become one of the foundations of modern finance. Interest payments are the primary way commercial banks make their money.
Most commonly, an interest payment will be a recurring payment at fixed intervals, known as an interest rate. The rate of interest is usually expressed as a percentage of the principal (the amount borrowed). The rate a creditor will charge on the loan they provide is influenced by the amount being borrowed, creditworthiness of the borrower, and economic aspects such as the money supply, fiscal policy, and rate of inflation. Commercial banks aren’t the only economic entities utilising interest. Central banks manipulate interest rates as one of the main ways to control inflation. When national interest rates are high, people are more inclined to curb their spending and put their money into saving. When they are low, it is a good time to invest and spend.
Fixed vs Variable Interest
Often, borrowers can choose whether they’d like to borrow at a fixed or variable interest rate. Fixed interest rates remain static, despite what the central bank interest rate may do. A fixed rate loan is a good option for a borrower who believes the interest rates will go up. If this happens, their interest repayments will remain the same regardless, meaning they are effectively beating the market price for credit. Cash becomes cheaper in a deflation (which higher interest rates are designed to cause). Variable rates of interest, on the other hand, will fluctuate as the market does. If a borrower believes interest rates will be lowered, a variable interest rate is the more sensible option when applying for credit.
How Is Interest Calculated?
Interest is often calculated in one of two ways: simple or compound. Simple interest is based exclusively on the principal, and is commonly used in mortgage payments. Simple interest may be calculated as follows:
Formula For Simple Interest: Principal amount x Annual interest rate x Number of years.
Compound interest is also based on the principal, but with interest added to the principal itself so that the added interest also effectively earns interest from then on. For example, if the loan is of £10 at an interest of 4%, the 4% is first added to the principal, making it £10.40. Then, the 4% interest is applied again on that figure, making the total interest repayment now £10.82. This additional interest is added periodically, in ‘compounding periods’. The more frequently these periods occur, the more rapidly compound interest will grow. Because of this effect, the amount of compound interest accrued on £100 compounded at 10% annually will be lower than that on £100 compounded at 5% bi-annually over an equivalent time period. Loans on compound interest are more risky for the borrower, as the amount of money to repay will grow much faster than loans on simple interest.
Formula For Compound Interest = Principal amount(1 + Annual Rate Of Interest/Number Of Compounding Periods A Year)^(Number Of Compounding Periods A Year x Number Of Years Borrowed For)
Did you find this interest definition helpful? Subscribe to our spam-free newsletter to receive regular financial definitions, updates on our latest articles, plus exclusive annotated market reports.