Difference between Gross Interest and Net Interest

This article will help you to learn about the difference between gross interest and net interest.

Difference between Gross Interest and Net Interest

Meaning of Interest:

What is it that catches your eye when you enter a big factory?

It is the machine and not the man behind it. Huge and powerful, the machine must have cost a very large amount of money.

And there are many such machines in a factory. We cannot expect one man alone to buy them out of his own pocket. Hence capital has to be borrowed for the purposes of large-scale production. The payment made to its owner for the use of capital’ is called ‘interest’.

In old times, this factor was not so important. The two primary factors, man and nature, were much more important. In modern times, capital has come into prominence and the part played by it in production is growing in importance with the passing of years.

It should be borne in mind that the term ‘interest’, as it is used in Economics, does not refer to the total amount paid by a borrower, but to that part of this payment which can be attributed to the use of capital only and for nothing else. Much of what is generally called interest is not the price of the service of capital as such. It is a mixture of pure interest, which is a reward for the use of capital, and several other payments for other services. This leads to the distinction between gross interest and net interest.

Gross and Net Interest:

Distinction may be made between gross interest and net interest. What a man pays to his creditor periodically for the use of capital is called interest in everyday speech. But the whole of this payment is not the true price for the use of capital. It contains other elements too. It is better to call this payment ‘gross interest’. Of this, ‘net interest’ is but a part.

Gross interest consists of the following terms:

(i) Insurance against Risk:

When money is lent, there is some risk of its not being returned. The borrower may prove a cheat or he may not be in a position to pay back. The risk may thus be a personal risk or business risk. The lender, therefore, expects a reward in proportion to the degree of risk involved.

This is one of the reasons why the money-lender in Indian villages charges high rates of interest from the peasant. For the same reason the lender asks for security. It may be jewellery, house, or land. Modern banks too usually demand a security. Thus, a part of the payment called interest is insurance against risk.

(ii) Reward for Management:

Besides running a risk, the money-lender has to keep a record of all repayments and charges. He has also to keep reminding his debtors by post and through personal visits. He deserves some payment for “his kind of work. This is a whole-time job and he must receive remuneration for this. Thus, gross interest includes, besides other things, remuneration for management.

(iii) Payment for Inconvenience:

The lender also charges a higher rate of interest if he is not sure of the interest and the principal being repaid in time. To pursue evasive clients for payment is awfully troublesome. A part of gross interest paid is to compensate the lender for this inconvenience.

The inconven­ience lies in this that the lender may not get back the money when he needs it or he jets it at a time when he cannot invest it safely and profitably. In the first case, he may have to borrow himself and, in the second case, he may lose interest. In both cases, he must compensate himself by charging something over and above pure or net interest. This is another element of gross interest.

(iv) Net Interest:

After all the above items have been deducted from gross interest, what is left is the payment pure and simple for the use of capital. This is net or pure interest. The money invested in ‘gilt-edged securities’ like Government bonds or treasury bills runs very little risk of being lost.

Hence, the interest paid on such investments does not include much of the other elements. It is the nearest to net interest. Fig. 34.1 illustrates the idea clearly. In this figure, the shaded area is net interest, whereas other payments included in gross interest are over and above and are shown in outer margin of net profit.

Differences in Gross Interest:

The distinction between gross and net interest is very helpful. When we find widely different rates of interest being charged in various places and from different persons, we know that the differences are in gross interest only. Net interest tends to be the same provided there is perfect mobility of capital. Thus, it tends to be uniform everywhere when all payments for inconvenience and risks are deducted.

Differences in Net or Pure Interest:

While gross interest may vary on account of differences in respect of the factors enumerated above, it is common observation that pure interest may also be different in different investments.

Such differences are usually due to the following reasons:

(a) Difference due to Distances:

People are usually more willing to invest their capital nearer home than at a long distance. This may create differences in supply and demand due to the comparative immobility of capital.

(b) Differences due to Time:

Another reason for differences in interest rates is the maturity period of the loan, i.e., the length of the loan. Other things being equal, long-term loans will carry higher rates of interest than do short-term loans, since the long-term lenders suffer greater inconvenience and possible financial sacrifice of foregoing alternative uses for their money for a longer period of time.

On a long-term loan, there is a risk of drop in the value of the securities or a possible rise in the price level. The lender must, therefore, charge more to cover the possible loss. Hence, a long-term bond will have to offer a ‘higher rate of interest than a short-term bond, other things being equal.

(c) Differences due to the Amount of the Loan:

It is generally seen that the rate of interest varies inversely with the amount of the loan. The rate decreases a., the amount of the loan increases, and vice versa.

(d) Monopoly Factor:

A bank in a small town which has a monopoly in the local money market may charge higher rate of interest from the local people, because those people find it inconvenient to seek loans from banks in distant cities.