Understanding Interest

It is interesting to note that centuries before people considered a loan or credit to be an amount that a neighbor lent out to another in the latter's misery. Unlike today, in those days, making a profit or accepting an interest from granting a loan was considered to be immoral or unfair.

It may be mentioned here that the term 'usury' has been derived from the Latin word usura that denotes making use of something, for instance, a borrowed sum. At one time, the term usury was described as an instance 'where a lesser amount is granted than what was asked for' and the practice was considered as an illegal or immoral act by the church authorities as well as the governments. On the contrary, asking for an interest on a loan or fees on lending out money was regarded equivalent to committing a burglary. Interestingly, today charging an interest is not considered to be a theft any more, but charging too much interest on a loan is definitely described as usury.

Contrary to the earlier views, people slowly but surely became aware of the fact that lending out money was a potential risk for the creditor. Hence, the interest factor came into existence with a view to protect the interests of the lender. In fact, the term interest has been derived from the Latin word 'intereo' denoting 'to be lost'. Over the years, the word interest denoted a loss or financial beating often suffered by a lender. Later, loss meant recompense to a lender for the loss incurred by him or her through lending money. In other words, the loss meant a difference between circumstances where a creditor does not lend any money and where he or she has granted a loan.

In fact, in earlier times all loans were usually bereft of any interest. However, the loan was associated with a financial punishment, considered to be an interest, if the borrower failed to repay the borrowed amount within the stipulated period. This aspect made the lenders aware of the possibility of making money by lending money and in the course of time they began to take a fee for the money they lent out at the very beginning of the credit term.

Presently, there are two kinds of interest rates in the mortgage market - simple or fixed interest and compound interest. As is evident from the term, simple or fixed interest is calculated only on the principal loan amount or the borrowed sum. On the other hand, compound interest may be described as an interest on interest. In the instance of compound interest, the interest is calculated not only on the principal loan amount, but also the interest that has accrued over pre-determined periods - annually, semi-annually or other interludes.

In brief, simple interest is best described as interest on the principal. An ideal example of simple interest is when an individual borrows an amount from the lender with a commitment to repay the loan amount and an additional 10 per cent on the credit with no fixed repayment date. This additional 10 per cent payment promised by the borrower is calculated on the principal loan amount or the borrowed sum.

On the other hand, if an individual secures a credit with the commitment to repay the loan with 10 per cent interest within one year, this automatically assumes the nature of a compound interest. For, if the borrower is unable to repay the loan within the promised one year time period, then the 10 per cent interest on the principal will be added to the obligation or the outstanding amount. Therefore, when the borrower eventually repays the loan at a later date, he or she will be paying a higher interest on the outstanding amount. The interest in this case will include interest on the borrowed sum on the number of years the loan has been in effect as well as the interest on the accrued interest.

As it has been mentioned earlier, one needs to always bear in mind that the more often the interest is computed, the more the earning for the lender. The table below illustrates the interest amount if it is compounded once in six months or semi-annually on a loan worth $1,000 at 10 per cent annual rate.

1st period (6 months)10% / 2 x 1,000.00 = $50.00
2nd period (6 months)10% / 2 x 1,050.00 = $52.50
Total interest paid$102.50

From the above table it is evident that though the interest rate on the loan is quoted as 10 per cent per annum, in effect, the lender receives a higher sum - 10.25 per cent - at the end of the year.

Well, with all other factors remaining constant, what would be the results if the interest on the loan is calculated quarterly or once in every three months? The table below exemplifies the outcome in such an instance.

1st period (3 months)10% / 4 x 1,000.00 = $25.00
2nd period (3 months)10% / 4 x 1,025.00 = $25.62
3rd period (3 months)10% / 4 x 1,050.62 = $26.26
4th period (3 months)10% / 4 x 1,076.89 = $26.92
Total interest paid$103.80

A comparison between the above two tables substantiate the point that when the interest on a loan is compounded more frequently, the borrower stands to lose as the lender's earning go up. You have seen that when a loan amount of $1,000 at 10 per cent annual interest rate is calculated semi-annually or twice in a year, the lender actually receives 10.25 per cent at the end of the year. Similarly, when the same loan at the same interest rate is computed quarterly or once in three months, the lender receives 10.38 per cent annually. However, it must be noted that the figures of actual repayment shown in the above tables are only applicable when the interest on the loan is paid annually. These are ideal examples of the interest rates being calculated at different periods and the actual interest being paid at a different time.

On the contrary, the lender would not have made any additional gains in the form of interest payments if the borrowers paid the interest amount at the time of its calculation. This is because if the interest sum was paid to the lender right at the time of its calculation, the money would not generate any interest on it. In this case, the lender would be receiving the agreed 10 per cent interest annually, irrespective of the time of the interest calculation. For instance, if the lender agreed to accept the interest amount in two installments, the borrower would pay him or her $50 each on the completion of six months. Since the lender would have already received $50 after the first six months, it would not be added to the principal loan amount and the lender would not be entitled to any interest on this sum. In this instance, the interest would no longer remain a compound interest, but will be deemed as a simple or fixed interest.

The borrower would also not be required to pay anything more than the 10 per cent annual interest rate if he or she made the intermittent interest payments from the money he or she has stacked up some where. And utilizing money stacked in a shoe box never earns any interest or profit. This is one of the primary reasons why many say that compound interest generates effectual revenue.

On the other hand, if the creditor desires to earn 10.25 per cent interest on the quoted 10 per cent interest per annum, he or she would either have to receive the payments once in a year, or straight away put back the amount received as periodic payment of interest in another loan with similar terms and conditions. In simple words, the lender will not gain anything by keeping the intermittent interest payment amount with him, but will have to reinvest the sum in a profitable business to earn a higher yield. On this will enable the lender to reap the benefits of the compounding system and earn 10.25 per cent on 10 per cent.

It is normally quite simple to determine the interest rates (also known as factors) on a loan when the payments are made at regular intervals. In order to find out the periodic interest factor on a credit where the interest is calculated every month, just break up the yearly interest rate by 12. On the other hand, if the interest is compounded semi-annually divide the annual interest rate by two and by four if it is calculated on a quarterly basis.

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