Interest

Loading the player...

What is 'Interest'

Interest is the charge for the privilege of borrowing money, typically expressed as annual percentage rate. Interest can also refer to the amount of ownership a stockholder has in a company, usually expressed as a percentage.

BREAKING DOWN 'Interest'

There are two main types of interest that can be applied to loanssimple and compound. Simple interest is a set rate on the principle originally lent to the borrower that the borrower has to pay for the ability to use the money. Compound interest is interest on both the principle and the compounding interest paid on that loan. The latter of the two types of interest is the most common.

Some of the considerations that go into calculating the type of interest and the amount a lender will charge a borrower include opportunity cost (the cost of the inability of the lender to use the money they’re lending out), the amount of expected inflation, the risk that the lender is unable to pay the loan back because of default, the length of time that the money is being lent out for, the possibility of government intervention on interest rates, and the liquidity of the loan being made.

A quick way to get a rough understanding of how long it will take in order for an investment to double is to use the rule of 72. Divide the number 72 by interest rate 72/4 for instance, and you’ll double your investment in 18 years. 

History

This cost of borrowing money is considered commonplace today, however the wide acceptability of interest became common only during the Renaissance.

Interest is an ancient practice; however, social norms from ancient Middle Eastern civilizations, to Medieval times regarded charging interest on loans as a kind of sin. This was due, in part because loans were made to people in need, and there was no product other than money being made in the act of loaning assets with interest. 

The moral dubiousness of charging interest on loans fell away during the Renaissance. People began borrowing money to grow businesses in an attempt improve their own station. Growing markets and relative economic mobility made loans more common, and made charging interest more acceptable. It was during this time that money began to be considered a commodity, and the opportunity cost of lending it was seen as worth charging for. 

Political philosophers in the 1700s and 1800s elucidated the economic theory behind charging interest rates for lent money, authors included Adam Smith, Frédéric Bastiat, and Carl Menger. Some of those titles included the Theory of Fructification by Anne-Robert-Jacques Turgo, and Interest and prices by Knut Wicksell. 

Iran, Sudan, and Pakistan removed interest from their banking and financial systems, making it so lenders partner in profit and loss sharing instead of charging interest on the money they lend. This trend in Islamic banking – refusing to take interest on loans – became more common towards the end of the 20th century. 

RELATED TERMS
  1. Interest Rate

    The amount charged, expressed as a percentage of principal, by ...
  2. Interest Cost

    The cumulative sum of the amount of interest paid on a loan by ...
  3. Interest Rate Ceiling

    The maximum interest rate that a financial institution can charge ...
  4. Periodic Interest Rate

    The interest rate charged on a loan or realized on an investment ...
  5. Simple Interest

    A quick method of calculating the interest charge on a loan. ...
  6. Closed-End Credit

    A loan or extension of credit in which the proceeds are dispersed ...
Related Articles
  1. Markets

    Explaining Interest

    Interest is the price charged to borrow money, and is typically expressed as a percentage of the principal, or the amount loaned.
  2. Markets

    Forces Behind Interest Rates

    Get a deeper understanding of the importance of interest rates and what makes them change.
  3. Markets

    Simple Interest Loans: Do They Exist?

    Yes, they do. Here is what they are – and how to use them to your advantage.
  4. Markets

    Simple Interest

    Simple interest is a quick method of calculating the interest charged on a loan. Simple interest is determined by multiplying the interest rate by the principal by the number of periods.
  5. Markets

    Forces Behind Interest Rates

    Interest is a cost for one party, and income for another. Regardless of the perspective, interest rates are always changing.
  6. Personal Finance

    The Difference Between Compounding Interest and Simple Interest

    Interest is the cost a borrower pays to use someone else’s money. Interest can be either simple or compounded.
  7. Markets

    How Banks Set Interest Rates on Your Loans

    Many factors go into how banks set interest rates for loans. Use this information to negotiate the best possible rate when you're borrowing.
  8. Investing

    Different Needs, Different Loans

    Find out what options are available when it comes to borrowing money.
  9. Managing Wealth

    4 Ways Simple Interest Is Used In Real Life

    Simple interest works in your favor when you're a borrower, but against you when you're an investor.
  10. Retirement

    Getting A Loan Without Your Parents

    Use the 5 "W"s to finance your dreams without banking on a second signature.
RELATED FAQS
  1. How can I tell if a loan uses simple or compound interest?

    Learn the differences between simple and compound interest and how you can use mathematical calculations and lender disclosures ... Read Answer >>
  2. How can I use the correlation coefficient to predict returns in the stock market?

    Read about simple interest loans, how they function, and some of the loan products or contracts that are most likely to carry ... Read Answer >>
  3. What is the difference between compounding interest and simple interest?

    Learn about simple interest and compound interest, how to calculate the two types of interest and the main difference between ... Read Answer >>
  4. How do I figure out my student loan fixed annual rate and APR?

    I'm trying to figure out my student loan rates. I've never taken out a loan before. It says 4.95% fixed annual ... Read Answer >>
  5. Which is better, a fixed or variable rate loan?

    A variable interest rate loan is a loan in which the interest rate charged on the outstanding balance varies as market interest ... Read Answer >>
  6. What are some examples of simple interest loans?

    Learn about two common examples of simple interest loans. Understand what simple interest is and learn why it's important ... Read Answer >>
Hot Definitions
  1. Put Option

    An option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security ...
  2. Frexit

    Frexit – short for "French exit" – is a French spinoff of the term Brexit, which emerged when the United Kingdom voted to ...
  3. AAA

    The highest possible rating assigned to the bonds of an issuer by credit rating agencies. An issuer that is rated AAA has ...
  4. GBP

    The abbreviation for the British pound sterling, the official currency of the United Kingdom, the British Overseas Territories ...
  5. Diversification

    A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique ...
  6. European Union - EU

    A group of European countries that participates in the world economy as one economic unit and operates under one official ...
Trading Center