Week 2: Lesson 1: Concept of Interest

INTEREST

An interest rate is the cost of borrowing money. Or, on the other side of
the coin, it is the compensation for the service and risk of lending
money. In both cases, it keeps the economy moving
by encouraging people to borrow, to lend, and to spend. However,
prevailing interest rates are always changing, and different types of loans
offer different interest rates.
If you are a lender, a borrower, or both, it is important you understand
the reasons for these changes and differences.
Key Takeaways
● An interest rate is the cost of borrowing money.
● Interest provides a certain compensation for bearing risk.
● Interest rate levels are a factor of the supply and demand of credit.
● The interest rate for each different type of loan depends on the
credit risk, time, tax considerations, and convertibility of the
particular loan.
Lenders and Borrowers
The moneylender takes a risk that the borrower may not pay back the
loan. Thus, interest provides a certain compensation for bearing risk.
Coupled with the risk of default is the risk of inflation. When you lend
money now, the prices of goods and services may go up by the time you
are paid back, so your money's original purchasing power would
decrease. Thus, interest protects against future rises in inflation. A lender
such as a bank uses the interest to process account costs as well.
Borrowers pay interest because they must pay a price for gaining the
ability to spend now, instead of having to wait years to save up enough
money. For example, a person or family may take out a mortgage for a
house for which they cannot presently pay in full, but the loan allows
them to become homeowners now instead of far into the future.
Businesses also borrow for future profit. They may borrow now to buy
equipment so they can begin earning those revenues today. Banks
borrow to increase their activities, whether lending or investing and pay
interest to clients for this service.
Interest can thus be considered as a cost for one entity and income for
another. It can represent the lost opportunity or opportunity cost of
keeping your money as cash under your mattress as opposed to lending
it. In addition, if you borrow money, the interest you have to pay could
be less than the cost of forgoing the opportunity of having access to the
money in the present.
DETERMINATION OF INTEREST RATE
Supply and Demand
Interest rate levels are a factor of the supply and demand of credit: an
increase in the demand for money or credit will raise interest rates, while
a decrease in the demand for credit will decrease them. Conversely, an
increase in the supply of credit will reduce interest rates while a decrease
in the supply of credit will increase them.
An increase for money made available to borrowers increases the supply
of credit. For example, when you open a bank account, you are lending
money to the bank. Depending on the kind of account you open (a
certificate of deposit will render a higher interest rate than a checking
account, with which you can access the funds at any time), the bank can
use that money for its business and investment activities. In other words,
the bank can lend out that money to other customers. The more banks
can lend, the more credit is available to the economy. And as the supply
of credit increases, the price of borrowing (interest) decreases.
Credit available to the economy decreases as lenders decide to defer the
repayment of their loans. For instance, when you choose to
postpone paying this month's credit card bill until next month or even
later, you are not only increasing the amount of interest you will have to
pay but also decreasing the amount of credit available in the market.
This, in turn, will increase the interest rates in the economy.

Inflation
Inflation will also affect interest rate levels. The higher the inflation rate,
the more interest rates are likely to rise. This occurs because lenders will
demand higher interest rates as compensation for the decrease in
purchasing power of the money they are paid in the future.
Government
The government has a say in how interest rates are affected. The RBI
often makes announcements about how monetary policy will affect
interest rates.
The rate that institutions charge each other for extremely short-term
loans, affects the interest rate that banks set on the money they lend.
That rate then eventually trickles down into other short-term lending
rates. The RBI influences these rates with "open market transactions,"
which is the buying or selling of previously issued securities. When the
government buys more securities, banks are injected with more money
than they can use for lending, and the interest rates decrease. When the
government sells securities, money from the banks is drained for the
transaction, rendering fewer funds at the banks' disposal for lending,
forcing a rise in interest rates.1
Interest keeps the economy moving by encouraging people to borrow, to
lend—and to spend.
Types of Loans
Of the factors detailed above, supply and demand are, as we implied
earlier, the primary forces behind interest rate levels. The interest rate
for each different type of loan, however, depends on the credit risk, time,
tax
considerations (particularly in the U.S.), and convertibility of the
particular loan.
Risk refers to the likelihood of the loan being repaid. A greater chance
that the loan will not be repaid leads to higher interest rate levels. If,
however, the loan is "secured," meaning there is some sort of collateral
that the lender will acquire in case the loan is not paid back (i.e., such as
a car or a house), the rate of interest will probably be lower. This is
because the risk factor is accounted for by the collateral.
For government-issued debt securities, there is, of course, minimal risk
because the borrower is the government. For this reason, and because the
interest is tax-free, the rate on treasury securities tends to be relatively
low.
Time is also a factor of risk. Long-term loans have a greater chance of
not being repaid because there is more time for the adversity that leads
to default. Also, the face value of a long-term loan, compared to that of a
short-term loan, is more vulnerable to the effects of inflation. Therefore,
the longer the borrower has to repay the loan, the more interest the
lender should receive.
Finally, some loans that can be converted back into money quickly will
have little if any loss on the principal loaned out. These loans usually
carry relatively lower interest rates.
The Bottom Line
As interest rates are a significant factor of the income you can earn by
lending money, of bond pricing and of the amount you will have to pay
to borrow money, it is important that you understand how prevailing
interest rates change: primarily by the forces of supply and demand,
which are also affected by inflation and monetary policy. Of course,
when you are deciding whether to invest in a debt security, it is
important to understand how its characteristics determine what kind of
interest rate you can receive.
What are the Different Types of Interest?
The three types of interest include simple (regular) interest, accrued
interest, and compounding interest. When money is borrowed, usually
through the means of a loan, the borrower is required to pay the interest
agreed upon by the two parties.
Simple (Regular) Interest

Simple or regular interest is the amount of interest due on the loan,

Accrued Interest
Accrued interest is accumulated interest that is unpaid until the end of
the period. If a loan requires monthly payments (at the end of each
month), interest steadily accumulates throughout the month.
Example:
If $30 is the interest expense each month, the loan is accruing $1 of
interest each day that requires payment once the end of the month is
reached. In this example, by day 15, the loan will have accumulated $15
in accrued interest (but require payment once $30 is reached).
Key Difference (Simple Interest vs. Accrued Interest):
The difference between these two types of interest are that regular
interest is paid periodically (determined by the loan agreement), and
accrued interest continues to be owed to the lender over time.
Compound Interest
Compounding interest essentially means “interest on interest.” The
interest payments change each period instead of staying fixed. Simple
interest is based solely on the principal outstanding, whereas compound
interest uses the principal and the previously earned interest.
Example:
If a person borrowed $1,000 with 2% interest and has $100 of accrued
interest, then that year’s interest would be $22. It is because the interest
is paid on the principal ($1000) and the accrued interest ($100), for a
total of $1100. 2% of $1100 is $22.,000 in a bank account that earns 4%
interest a year, you will have $5,200 by the end of the year. Now, if you
keep the $5,200 in the bank for another year, you will have $5,408.