The Idea Behind Interest

By Patrick Corby

Interest is the addition paid to have immediate access to some sum – the principle – instead of at some future time.

A loan offers immediate access to what otherwise cannot be afforded. It transfers present purchasing power to those in demand of it and away from those who have a willing supply of it. In this way the purchasing power or wealth of the suppliers decreases for a period of time. The interest paid on a loan is the separate payment for the privilege of transferred wealth to be paid back at a maturity date allocated to the loan.

Since the loaning of money holds risk, such as part or complete default, interest payments also account for the profit stemming from the undertaking of that entrepreneurial risk.

In addition to the default risk involved in the transference of wealth there is also the risk of the change in purchasing power stemming from credit manipulation or changes in the distribution of wealth. So that interest is also used as a hedge against the inflationary loss of purchasing power. Guaranteeing security the purchasing power being transferred back to the creditor once the loan has matured.

It should be noted that interest is not established through supply and demand of capital goods. It is supply and demand of capital goods that is driven by the interest rate. If the rate of interest is the privilege of immediate wants being satisfied over future wants then as the desires of individuals change in respect to consumption over saving or vica versa then so will the interest rate.

The market itself tends interest towards a equilibrium rate: if one sector has a lower interest compared to another then they will tend towards each other. This phenomenon occurs because of entrepreneurial activity picking up in sectors with high interest rates and trending downwards in those sectors that have lower interest rates. A market then tends towards a original interest rate fluctuating in response to the natural interest rate of each sector.

In Babylonia there have been tablets found detailing the use of interest in Mesopotamia; interest payments (simple and compound) have been legally established practices from at least the 18^th century BC.

Simple vs Compound Interest

There a two ways interest is calculated in finance: Simple and compounded.

Simple interest is the conception of the interest payment as a percentage to be paid each year the principle is held. So if a loan was took of £4500 at a simple 12% interest I would pay in 5 year until I paid the principle back. The interest I pay each year is £4500* 0.12 = £540.

To find the total interest paid on the principle then I have to times the interest ( r ) by the total years to maturity ( t ) and then times that total percentage by the principle itself ( P ), so that:

P (1 + r)

P (1 + 2r)

P (1 + 3r)

…

P (1 + tr)

Therefore:

£4500 (1 + (5* 0.12)

£4500 (1 + 0.6)

$4500 * 1.6

£4500 (1 + (5*.12) = £7200

The other more generally used kind of interest is ‘compound interest’ which allows for the annual, semi- annual or continuous interest payments to be assumed under the principle compounding. So that interest is paid on interest accumulated. If a loan is taken out for the principle of £4500 at an interest of 12% with a 5 year maturity then after the first year I owe £4500( 1 + 0.12) = £5040. But in the second year the principle subsumes the first years interest so that my new principle in the second year is £5040. The interest in the second year is :

£4500 (1 + 0.12) (1 + 0.12) or £4500 (1 + 0.12)²

So that after the second year the principle has compounded to £5644.8. After 5 years at a compound interest rate of 12% the principle owed has accumulated to:

P (1 + r)

P (1 + r)²

P (1 + r)³

…

P (1 + r)^t

Therefore:

£4500 (1 + 0.12)⁵

£4500 (1.12)⁵

£4500* 1.76

£4500 (1 + 0.12)⁵ = £7920

The two concepts above are the two ways of thinking about interest, with compounding being the most common form people come up against. Both are calculations used by us as economic agents to establish the payments due once we have decided on the natural interest rate on our money whatever subjective method we construct the interest rate with. This then aggregates into sectors which fluctuate as demand and supply of the sectors flows money in and out. These sectors then tend toward each other and are used to establish the origin interest rate in the aggregate.