What is Interest? Types of Interest
What is Interest?
In general, Interest is the price that a person or organization has to pay for borrowing money from another person or organization for a certain time. That means, the price paid by the borrower to the moneylender for the loan is called interest. For example – a person borrows 1000 rupees or Takas and promises to return 1200 rupees or Takas after one year. So, in this case the annual interest rate will be 20 percent. Interest is the extra money that the borrower pays to the moneylender after a certain time in addition to the original amount.
However, in Economics, Interest is the ‘rent’ paid for borrowing money or assets. The moneylender charges this interest on the loan. The original amount of money borrowed is called the principal or capital, and the portion of this principal or capital that has to be paid as interest over a time is called the interest rate.
Therefore, it can be said that interest is the money paid by the borrower to the owner of the capital for the use of the capital. The owner of capital earns interest because of the productivity of capital.
Types of Interest:
Interest is mainly of two types. Namely:
a. Gross Interest; and
b. Net Interest. Their description is given below:
(a) Gross Interest: Gross interest received by the moneylender in addition to the actual amount of capital. In this total interest, other than just the amount paid for the use of loan-capital, several other factors become involved. Other factors included in gross interest are risk-taking costs, loan bookkeeping costs, loan management costs, and loan-capital utilization costs. So the total amount paid by the borrower to the moneylender over and above the amount due to the borrower for utilizing the productive capacity of the capital, collection of debt management and bearing other inconveniences and risks is called gross interest.
(b) Net Interest: The amount paid to the owner of the capital over a time only for the productive use of the capital is called net interest. That means, after deducting loan management fees, loan collection costs and the cost of carrying loan risk, etc. from the gross interest, what remains is called net interest. Interest in Economics basically means net interest. Let’s say that a moneylender after lending 1000 rupees or Takas received 100 rupees or Takas as interest from the borrower after one year. These 100 rupees or Takas is the total interest. Out of These 100 rupees or Takas’ interest, 50 rupees or Takas are available for utilization of capital and incidental expenses i.e. 25 rupees or Takas for risk bearing, 15 rupees or Takas for debt management and 10 rupees or Takas for other difficulties of debt recovery. So, Net Interest = Total Interest – Incidental Expenses = 100 – (25 + 15 + 10) = 50 rupees or Takas.
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