Interest

What is ‘Interest’?

Interest is the charge for the privilege of borrowing money, typically expressed as annual percentage rate. Interest can also refer to the amount of ownership a stockholder has in a company, usually expressed as a percentage.

 

BREAKING DOWN ‘Interest’

There are two main types of interest that can be applied to loans: simple and compound. Simple interest is a set rate on the principle originally lent to the borrower that the borrower has to pay for the ability to use the money. Compound interest is interest on both the principle and the compounding interest paid on that loan. The latter of the two types of interest is the most common.

Some of the considerations that go into calculating the type of interest and the amount a lender will charge a borrower include opportunity cost (the cost of the inability of the lender to use the money they’re lending out), the amount of expected inflation, the risk that the lender is unable to pay the loan back because of default, the length of time that the money is being lent out for, the possibility of government intervention on interest rates, and the liquidity of the loan being made.
A quick way to get a rough understanding of how long it will take in order for an investment to double is to use the rule of 72. Divide the number 72 by interest rate 72/4 for instance, and you’ll double your investment in 18 years.

 

History

This cost of borrowing money is considered commonplace today, however the wide acceptability of interest became common only during the Renaissance.

Interest is an ancient practice; however, social norms from ancient Middle Eastern civilizations, to Medieval times regarded charging interest on loans as a kind of sin. This was due, in part because loans were made to people in need, and there was no product other than money being made in the act of loaning assets with interest.

The moral dubiousness of charging interest on loans fell away during the Renaissance. People began borrowing money to grow businesses in an attempt improve their own station. Growing markets and relative economic mobility made loans more common, and made charging interest more acceptable. It was during this time that money began to be considered a commodity, and the opportunity cost of lending it was seen as worth charging for.

Political philosophers in the 1700s and 1800s elucidated the economic theory behind charging interest rates for lent money, authors included Adam Smith, Frédéric Bastiat, and Carl Menger. Some of those titles included the Theory of Fructification by Anne-Robert-Jacques Turgo, and Interest and prices by Knut Wicksell.

Iran, Sudan, and Pakistan removed interest from their banking and financial systems, making it so lenders partner in profit and loss sharing instead of charging interest on the money they lend. This trend in Islamic banking – refusing to take interest on loans – became more common towards the end of the 20th century.