Interest
The Rate of Interest
Interest is the payment made for the use of the services of capital. It is a compensatory payment made to individuals in order to induce' them' to postpone' enjoyment of goods from the present to the future date. i.e. in order to make them have negative time preference for money.
Composition of interest
The payment which the borrower makes to the lender excluding the principle is gross interest. It is an aggregate of the following payments.
- Pure or net interest: It is the payment for the use of capital or money only. This is interest in the true economic sense. it is normally the same during a period of time for all markets.
- Reward for risk taking: The gross interest includes the reward for risk taking. It is assumed that the lender exposes himself to risk when he lends money. The greater the risk element, the higher the gross rate of interest. Thus unsecured loans are more risky than the secured ones and carry a high premium rate.
- Reward for inconvenience: When a lender lends money, he or she foregoes its use for the duration of the loan. It means the lender cannot use the money for more profitable purposes. Should the lender need this amount of money for personal use, he or she will have to undergo the inconvenience of arranging for it from other sources. As a result, when fixing the rate of interest, the lender includes in it the rewards for such inconvenience.
- Reward for management: The lender incurs high costs of managing the loans. This includes the expenditure in keeping the proper accounts of the borrowers. He may from time to time remind the borrower to pay for the loan and sometime have to file a suit for the recovery of the loans. Therefore the payment that the lender receives from, the borrower includes all these expenses for the loan management.