Interest: Definitions, Concept and Causes of Difference

Interest: Definitions, Concept and Causes of Difference in Rates of Interest!

In simple words, interest means the reward for the use of capital. It is also called the income of the owner of capital for lending it.

In other words, it is the price paid by the borrower of money to its lender. Now, question arises, why interest is paid?

The answer follows:

We know that people keep their money in three forms:

(i) In banks

(ii) In bonds, securities or debentures

(iii) In cash.

The third form has the advantage that this amount can be used at any time. Therefore, when one person parts with this amount, he gets a price which is known as interest.

Definitions:

The concept of interest can be explained in a number of ways as under:

“Interest is the price paid for the use of capital in any market.” -Marshall

“Interest is a reward for parting with liquidity for a specified period.” -J.M. Keynes

“Interest is the price paid for the hire of loan capital.” -Cairncross

“Interest is the income which goes to the lender of capital by virtue of its productivity as a reward for its abstinence.” -Carver

Concept of Interest:

There are two concepts of interest as:

1. Gross Interest

2. Net Interest

1. Gross Interest:

Gross interest refers to the entire payments made by the borrower to the lender on a certain amount of loan received for a period of time. It includes not only the payment for the use of money capital but also for risks, inconvenience and management.

Thus,

Gross Interest = Net Interest + Risk bearing + Reward for management + reward for inconvenience.

2. Net Interest:

Net interest is the payment purely made for the use of money. Net interest rate is determined by the forces of demand and supply of funds or money.It generally relates to public and is comparatively low to gross interest.

Causes of Difference in Rates of Interest:

The loan market is not characterized by the prevalence of one definite rate of interest. Rate of interest differs from place to place and from person to person. A number of factors bring about such a situation.

1. Nature of Security:

Interest rate varies with the type of property pledged behind the security. Loans borrowed against the security of gold carry less interest rate than loans against the security of immovable property like land or house.

2. Credit-Worthiness of the Borrower:

Interest also depends upon the credit standing of the borrowers. It is because of this reason that persons of known integrity and credibility can get loans on easy terms.

3. Liquidity:

Rate of interest also varies with the degree of liquidity of the asset offered as security against the loan. The greater the liquidity of the assets offered as security against the loan the lower will be the rate of interest and vice-versa.

4. Period of Loan:

Rate of interest also depends upon the period of loan. Long-term rate of interest is higher than the short term. In a long term loan, money gets locked up for a longer duration. Naturally, the lender wants to be compensated by a higher rate of interest.

5. Amount of Loan:

Rate of interest stands in an inverse relation to the amount of loan. The greater the amount of loan, the lower is the rate of interest and vice versa.

6. Difference Due to Distance:

Distance between the lender and the borrower also causes difference between rates of interest. People are willing to invest their capital at a lower rate of interest in ventures nearer home than at a long distance.

7. Differences in Productivity:

Productivity of capital differs from venture to venture. For highly productive ventures, people will be willing to borrow at a higher rate of interest and vice-versa.

8. Market Imperfections:

Differences in the interest rate also originate from market imperfections that may be found in a loan market. In the words of Professor Bober, “In a given locality the few commercial banks may constitute an oligopoly with a degree of monopoly behaviour, for short term commercial loans, their interest rates are then likely to stand above those which would rule under competition”. The discussion given above shows those different interest rates reflect differences in risk, length of loan amount and a host of other factors.

Can Interest be Zero?

There is a wide spread controversy among the economists whether the interest can be zero or not. Some economists opined that if marginal productivity of capital is zero and there is no saving and investment in the country, interest will be zero. But other economists refuted this version and remarked that in nature every economy is dynamic and marginal productivity of capital cannot be zero. Thus, there is no possibility for the rate of interest to be zero. A borrower has to pay some minimum amount of interest to the lender for the use of money capital. Therefore, rate of interest can never be zero.