Interest (Debt) - Explained
What is Interest?
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Table of ContentsWhat is Interest on Debt?How Does Interest Work?History of Interest RatesDifferent Interest RatesInterest Rates and Credit ScoreLow Interest Rate Environments
What is Interest on Debt?
Interests refer to the amount that a lender charges a borrower for borrowing money or using the lenders assets. It is the amount a borrower must pay to a lender for taking a loan or borrowing an asset. Interest charged by lenders is on an annual basis and is therefore expressed as the annual percentage rate (APR). In stock ownership, interest refers to the number of company stocks that a stockholder holds, this is often expressed as a percentage of a company's stock.
How Does Interest Work?
Interest refers to a distinct fee that a borrower pays to a lender in addition to the loan principal. A loan can either have a simple interest or compound interest. When simple interest is used, it refers to the fixed rate that the lender sets over the principal loan obtained by a borrower. Compounding interest, on the other hand, refers to the interest calculated on the initial principal and compounded or accumulated interest paid on the loan. The compound interest is often used by lenders in most loans. Interest is calculated as an annual percentage paid on the principal that lenders charge. When calculating interest, there are certain factors that must be considered, they are;
- The cost of the inability of the lender to use the money for the period of time it is lent to the borrower.
- Duration of the loan.
- Anticipated inflation or inflationary rate.
- The creditworthiness of the borrower.
- Risk of default on the repayment of the loan.
- Fiscal or monetary policy can affect interest rates.
- Money supply or liquidity of the loan.
History of Interest Rates
Interest has been practiced and used over a long period, it first started during the medieval times but at this time, it was unpopular. Many people saw charging interest on loans as a sinful act and lenders who charge interest on their loans are regarded dubious. Due to the fact that loans are given to those in dire need of money during the era, interest was not a common practice. In the 17th and 18th centuries, authors and economists such as Adam Smith, Anne-Robert-Jacques, Frdric Bastiat, Knut Wicksell, and Carl Menger, expatiated the economic theory of charging interest on loans. Charging of interest became a common practice during the Renaissance period. Before interest gained popularity, certain religious practices prohibited the charging of interests on loans. For instance, in countries like Sudan, Pakistan, and Iran where Islamic banking is practiced, interest was removed in the banking and financial systems of these countries.
Different Interest Rates
Since the popular acceptance of interest has occurred, interest rates are used for various loan services and financial products such as personal loans, business loans, mortgage loans, automobile loans, and others. Different countries have different interest rates which are mostly influenced by money supply, inflation, fiscal policy, among others. The United States had to increase interest rates about three times in 2017 as a result of low GDP and the unemployment rate in the U.S. Also, the interest rate charged in different sectors differ, for interest, interests charged for mortgages, auto loans, credit loans, and business loans vary.
Interest Rates and Credit Score
Lenders offer different rates to different individuals using their credit score otherwise called creditworthiness. Individuals with poor credit scores are exposed to higher interest rates unlike individuals with high credit scores who are offered low-interest-rate by lenders. In 2018, the annual percentage rate (APR) charged on a personal loan for individuals with a credit score of 850 to 720 is between 10.3% to 12.5%. Individuals with a poor credit score of 300 to 639 have APRs of 28.5% to 32.0%.
Low Interest Rate Environments
There are certain regions or countries that charge ow interest rates on loans, environments of this nature aim to foster economic growth through low interests. Borrowing loans in an environment with low-interest rates is also cheaper compared to advanced regions that have high-interest rates. Banks and financial institutions located in low-interest-rate environments enjoy higher patronage than those in advanced communities because they lend more money to many people. Low-interest rate indicates poor economic growth in countries and environments that practice them. Low return on investments is another feature of low-interest rate environments. Countries with high economic growth use high-interest rates.