Interest

Interest is a fee, paid on borrowed capital. Assets lent include money, shares, consumer goods through hire purchase, major assets such as aircraft, and even entire factories in finance lease arrangements. The interest is calculated upon the value of the assets in the same manner as upon money. Interest can be thought of as "rent on money". For example, if you want to loan money from the bank, there is a certain rate you have to pay according to how much you want to loan. This is how banks make money.

The fee is compensation to the lender for foregoing other useful investments that could have been made with the loaned money. Instead of the lender using the assets directly, they are advanced to the borrower. The borrower then enjoys the benefit of using the assets ahead of the effort required to obtain them, while the lender enjoys the benefit of the fee paid by the borrower for the privilege. The amount lent, or the value of the assets lent, is called the principal. This principal value is held by the borrower on credit. Interest is therefore the price of credit, not the price of money as it is commonly - and mistakenly - believed to be. The percentage of the principal that is paid as a fee (the interest), over a certain period of time, is called the interest rate.

History of interest

Interest is the price paid for the use of savings over a given period of time. In the Middle Ages, time was considered to be property of God. Therefore, to charge interest was considered to commerce with God's property. Also, St. Thomas Aquinas, the leading theologian of the Catholic Church, argued that the charging of interest is wrong because it amounts to "Usury#Usury in scholastic theology|double charging", charging for both the thing and the use of the thing. The church regarded this as a sin of usury; nevertheless, this rule was never strictly obeyed and eroded gradually until it disappeared during the industrial revolution. Some scholars think that banking started among Jewish families because of the restrictions of the church.

... financial oppression of Jews tended to occur in areas where they were most disliked, and if Jews reacted by concentrating on money lending to gentiles, the unpopularity - and so, of course, the pressure - would increase. This is that the Jews became an element in a vicious circle. The Christians, on the basis of the Biblical rulings, condemned interest-taking absolutely, and from [[1179]] those who practiced it were excommunicated. But the Christians also imposed the harshest financial burdens on the Jews. The Jews reacted by engaging in the one business where Christian laws actually discriminated in their favor, and so became identified with the hated trade of moneylending.

Usury has always been viewed negatively by the Roman Catholic Church. The Second Lateran Council condemned any repayment of a debt with more money than was originally loaned, the Council of Vienna explicitly prohibited usury and declared any legislation tolerant of usury to be heretical, and the first scholastics reproved the charging of interest. In the medieval economy, loans were entirely a consequence of necessity (bad harvests, fire in a workplace) and, under those conditions, it was considered morally reproachable to charge interest.

In the Renaissance era, greater mobility of people facilitated an increase in commerce and the appearance of appropriate conditions for entrepreneurs to start new, lucrative businesses. Given that borrowed money was no longer strictly for consumption but for production as well, it could not be viewed in the same manner. The School of Salamanca elaborated various reasons that justified the charging of interest. The person who received a loan benefited and one could consider interest as a premium paid for the risk taken by the loaning party. There was also the question of opportunity cost, in that the loaning party lost other possibilities of utilizing the loaned money. Finally and perhaps most originally was the consideration of money itself as merchandise, and the use of one's money as something for which one should receive a benefit in the form of interest.

Martín de Azpilcueta also considered the effect of time. Other things being equal, one would prefer to receive a given good now rather than in the future. This preference indicates greater value. Interest, under this theory, is the payment for the time the loaning individual is deprived of the money.

Economically, the interest rate is the cost of capital and is subject to the laws of supply and demand of the money supply. The first attempt to control interest rates through manipulation of the money supply was made by the French Central Bank in 1847.

The first formal studies of interest rates and their impact on society were conducted by Adam Smith, Jeremy Bentham and Mirabeau during the birth of classic economic thought. In the early 20th century, Irving Fisher made a major breakthrough in the economic analysis of interest rates by distinguishing nominal interest from real interest. Several perspectives on the nature and impact of interest rates have arisen since then. Among academics, the more modern views of John Maynard Keynes and Milton Friedman are widely accepted.

Former Central President of the JUP Sahibzada Fazal Karim MNA has stated that the Council of Islamic ideology feels that Islamic banking ought to be interest-free by law.

Types of interest

Simple interest

Simple Interest is calculated only on the principal, or on that portion of the principal which remains unpaid.

Compound interest

Compound interest is very similar to simple interest, however, as time goes on the difference becomes considerably larger. The conceptual difference is that unpaid interest is added to the balance due. Put another way, the borrower is charged interest on previous interest charges.

Fixed and floating rates

Commercial loans generally use compound interest, but they may not always have a single interest rate over the life of the loan. Loans for which the interest rate does not change are referred to as fixed rate loans. Loans may also have a changeable rate over the life of the loan based on some reference rate (such as LIBOR and EURIBOR), usually plus (or minus) a fixed margin. These are known as floating rate, variable rate or adjustable rate loans.

Combinations of fixed-rate and floating-rate loans are possible and frequently used. Less frequently, loans may have different interest rates applied over the life of the loan, where the changes to the interest rate are governed by specific criteria other than an underlying interest rate. An example would be a loan that uses specific periods of time to dictate specific changes in the rate, such as a rate of 5% in the first year, 6% in the second, and 7% in the third.

Composition of interest rates

In economics, interest is considered the price of money, therefore, it is also subject to distortions due to inflation. The nominal interest rate, which refers to the price before adjustment to inflation, is the one visible to the consumer (''i.e.'', the interest tagged in a loan contract, credit card statement, etc). Nominal interest is composed by the real interest rate plus inflation, among other factors.

Cumulative interest or return

Cumulative interest/return: This calculation is (FV/PV)-1. It ignores the 'per year' convention and assumes compounding at every payment date. It is usually used to compare two long term opportunities.

Other conventions and uses

Other exceptions:

* US and Canadian T-Bills (short term Government debt) have a different convention. Their interest is calculated as (100-P)/P where 'P' is the price paid. Instead of normalizing it to a year, the interest is prorated by the number of days 't': (365/t)*100. (See also: Day count convention). The total calculation is ((100-P)/P)*((365/t)*100). This is equivalent to calculating the price by a process called discounting at a simple interest rate.

* Corporate Bonds are most frequently payable twice yearly. The amount of interest paid is the simple interest disclosed divided by two (multiplied by the face value of debt).

Flat Rate Loans and the Rule of 78s: Some consumer loans have been structured as flat rate loans, with the loan outstanding determined by allocating the total interest across the term of the loan by using the "Rule of 78s" or "Sum of digits" method. Seventy-eight is the sum of the numbers 1 through 12, inclusive. The practice enabled quick calculations of interest in the pre-computer days. In a loan with interest calculated per the Rule of 78s, the total interest over the life of the loan is calculated as either simple or compound interest and amounts to the same as either of the above methods. Payments remain constant over the life of the loan; however, payments are allocated to interest in progressively smaller amounts. In a one-year loan, in the first month, 12/78 of all interest owed over the life of the loan is due; in the second month, 11/78; progressing to the twelfth month where only 1/78 of all interest is due. The practical effect of the Rule of 78s is to make early pay-offs of term loans more expensive. For a one year loan, approximately 3/4 of all interest due is collected by the sixth month, and pay-off of the principal then will cause the effective interest rate to be much higher than the APY used to calculate the payments.

In [[1992]], the United States outlawed the use of "Rule of 78s" interest in connection with mortgage refinancing and other consumer loans over five years in term. Certain other jurisdictions have outlawed application of the Rule of 78s in certain types of loans, particularly consumer loans.

Rule of 72: The "Rule of 72" is a "quick and dirty" method for finding out how fast money doubles for a given interest rate. For example, if you have an interest rate of 6%, it will take 72/6 or 12 years for your money to double, compounding at 6%. This is an approximation that starts to break down above 10%.

Market interest rates

There are markets for investments which include the money market, bond market, as well as retail financial institutions like banks, which set interest rates. Each specific debt takes into account the following factors in determining its interest rate:

Opportunity cost: This encompasses any other use to which the money could be put, including lending to others, investing elsewhere, holding cash (for safety, for example), and simply spending the funds.

Inflation: Since the lender is deferring his consumption, he will at a bare minimum, want to recover enough to pay the increased cost of goods due to inflation. Because future inflation is unknown, there are three tactics.

* Charge X% interest 'plus inflation'. Many governments issue 'real-return' or 'inflation indexed' bonds. The principal amount and the interest payments are continually increased by the rate of inflations. See the discussion at real interest rate.

* Decide on the 'expected' inflation rate. This still leaves both parties exposed to the risk of 'unexpected' inflation.

* Allow the interest rate to be periodically changed. While a 'fixed interest rate' remains the same throughout the life of the debt, 'variable' or 'floating' rates can be reset. There are derivative products that allow for hedging and swaps between the two.

Default: There is always the risk the borrower will become bankrupt, abscond or otherwise default on the loan. The risk premium attempts to measure the integrity of the borrower, the risk of his enterprise succeeding and the security of any collateral pledged. For example, loans to developing countries have higher risk premiums than those to the US government due to the difference in creditworthiness. An operating line of credit to a business will have a higher rate than a mortgage.

Creditworthiness of businesses is measured by bond rating services and individual's credit scores by credit bureaus. The risks of an individual debt may have a large standard deviation of possibilities. The lender may want to cover his maximum risk. But lenders with portfolios of debt can lower the risk premium to cover just the most probable outcome.

Deferred consumption: Charging interest equal only to inflation will leave the lender with the same purchasing power, but he would prefer his own consumption NOW rather than later. There will be an interest premium of the delay. See the discussion at time value of money. He may not want to consume, but instead would invest in another product. The possible return he could realize in competing investments will determine what interest he charges.

Length of time: Time has two effects.

* Shorter terms have less risk of default and inflation because the near future is easier to predict. Broadly speaking, if interest rates increase, then investment decreases due to the higher cost of borrowing (all else being equal).

Interest rates are generally determined by the market, but government intervention - usually by a central bank- may strongly influence short-term interest rates, and is used as the main tool of monetary policy. The central bank offers to buy or sell money at the desired rate and, due to their control of certain tools (such as, in many countries, the ability to print money) they are able to influence overall market interest rates.

Investment can change rapidly to changes in interest rates, affecting national income, and, through Okun's Law, changes in output affect unemployment.

Open market operations in the United States

The Federal Reserve (often referred to as 'The Fed') implements monetary policy largely by targeting the federal funds rate. This is the rate that banks charge each other for overnight loans of federal funds. Federal funds are the reserves held by banks at the Fed.

Open market operations are one tool within monetary policy implemented by the Federal Reserve to steer short-term interest rates. Using the power to buy and sell treasury securities, the Open Market Desk at the Federal Reserve Bank of New York can supply the market with dollars by purchasing T-notes, hence increasing the nation's money supply. By increasing the money supply or Aggregate Supply of Funding (ASF), interest rates will fall due to the excess of dollars banks will end up with in their reserves. Excess reserves may be lent in the Fed funds market to other banks, thus driving down rates.

Interest rates and credit risk

It is increasingly recognized that the business cycle, interest rates and credit risk are tightly interrelated. The Jarrow-Turnbull model was the first model of credit risk which explicitly had random interest rates at its core. Lando (2004), Darrell Duffie and Singleton (2003), and van Deventer and Imai (2003) discuss interest rates when the issuer of the interest-bearing instrument can default.

Money and inflation

Loans, bonds, and shares have some of the characteristics of money and are included in the broad money supply.

By setting i*_n, the government institution can affect the markets to alter the total of loans, bonds and shares issued. Generally speaking, a higher real interest rate reduces the broad money supply.

Through the quantity theory of money, increases in the money supply lead to inflation. This means that interest rates can affect inflation in the future.