Interest Definition

True Tamplin

Written by True Tamplin, BSc, CEPF®
Updated on January 26, 2021

Interest is the cost to borrow money from an individual or a financial institution. For investors, it can be a reward for saving money in a financial instrument, such as a certificate of deposit.

Interest is generally expressed as a percentage of the principal amount and charged or disbursed on a periodic basis. For example, an annual interest charge of 5% on a principal amount of $1,000 means that the borrower has to pay $50 per year as interest on the loaned amount.

While cash is the most commonly-used mechanism to borrow and payout interest, other assets, such as inventory, can also be used. For example, a building owner may rent out an apartment at reduced rate or free of cost to a lender as interest payment.

Perspectives of interest change based on the party’s role in the transaction. A lender charges interest and a borrower pays interest, whereas an asset or an investor earns interest.

History of Interest

The first recorded use of interest was in the Middle East. The code of Hammurabi prescribes limits on the amount of interest that can be charged for debt. As interest became common in society, predatory lenders gave it an unsavory reputation. Both Judaism and Islam prohibited the charging of high interest rates because it resulted in an inequitable transaction. Other cultures and religions also had a similarly negative perception of interest. Charging of high interest rates was forbidden through explicit laws in ancient Indian society. Buddhist folk tales characterized usurers and predatory lenders as evil.

That view changed during the Renaissance when trade and commerce became important to the economy. Interest rates became a means to generate wealth. Goldsmiths and scriveners became quasi-bankers and lent money at specific interest rates in exchange for the precious metal and other valuables. The Medici family built a banking empire by sneaking interest into letters of credit and bills of exchange that were used to circumvent church bans on usury.

In modern society, interest plays a central role in the functioning of an economy. Interest rates set by a central bank are responsible for setting a country’s monetary policy. When an economy is overheated, the central bank raises interest rates in order to cool it down. On the other hand, low interest rates are used to spur spending in a struggling economy. Interest rates can also be manipulated by controlling monetary supply. The Banque de France was the first financial institution to do so in 1847.

How is Interest Calculated?

Interest charges are known as interest rates. Most commercial and personal loans charge an Annual Percentage rate or APR which refers to the percentage rate of interest charged annually plus fees for the service. An APR can be used to compare two loans with each other.

Interest can be calculated in three ways:

  • In Simple Interest calculations, only the principal amount is used to calculate interest charges. Interest previously earned or charged is not added to the principal amount. For example, a 10-year loan of $100 at 10% simple interest annually would require interest payments of $10 each year.
  • In Accrued interest calculations, the interest calculation is accrued or calculated based on the unpaid amount for each month. In the previous example, the accrued interest would amount to $0.027 on a daily basis. Accrued interest is used in instances where regular interest payments are not necessary or can be deferred until the next period.
  • In Compound Interest calculations, the previous principal amount plus interest charges are added up for a new principal, which is used to calculate fresh interest charges. The interest charged increases exponentially over the duration of the borrowing period in compound interest. In the example cited above, if the interest rate is charged on a compounding basis, then interest payment for the next year is $11 because it is 10% of $110 (the new principal amount after the first year).

These are simple examples. In reality, calculation of interest charges for loans incorporates several variables. Some of them are:

  • Opportunity cost for the lender to not use their money
  • Federal funds rate
  • Inflation
  • Loan timeframe
  • Whether the lender can collect collateral in the event of a default

For example, the interest on your credit card is calculated using an annual percentage rate that is determined by various factors, such as your banking history, credit scores etc. The daily balance on your card is multiplied by the daily rate (calculated by dividing your APR by 365) to come up with an interest charge. The charge calculated is compounded i.e., it is added to the next day’s balance and the interest is calculated again. This is the reason why it is always a good idea to make a minimum (or complete) balance payment on time each time.

Role of Interest in Modern Economy

Interest is critical to the functioning of the modern economy. It is an instrument for capital accumulation because it provides monetary returns on credit. Without interest, there would be no incentive for banks and financiers to lend money to entrepreneurs and businesses and earn returns on their investment. Interest also affects inflation. When interest rates are high, households save money and demand decreases. In turn, inflation may decrease. The opposite happens when interest rates are high and demand increases. A country’s central bank is responsible for setting interest rates that are, subsequently, propagated down into consumers through intermediary banks and financial services institutions. Banks are not the only places which charge you interest; all financial products, whether car loans or tax payments, have interest fee tacked onto them.

Interest FAQs

Interest is an amount of money charged to a borrower as the cost of taking out a loan or issuing debt. This is expressed as a percentage of the principal of the amount borrowed.
Simple interest is calculated as a percentage of the principal that is periodically added to the total amount due.
To calculate compound interest, use the equation: Principal*[(1+interest rate)n-1]z
When interest compounds, it means that every time an amount is added to the principal, the interest rate takes a percentage of the new amount instead of the original principal.