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.

There are two main types of interest that can be applied to loans: simple 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. (Here is a loan calculator).

Interest rate is the amount charged, expressed as a percentage of principal, by a lender to a borrower for the use of assets. Interest rates are typically noted on an annual basis, known as the annual percentage rate (APR). The assets borrowed could include, cash, consumer goods, large assets, such as a vehicle or building. Interest is essentially a rental, or leasing charge to the borrower, for the asset’s use. In the case of a large asset, like a vehicle or building, the interest rate is sometimes known as the lease rate. When the borrower is a low-risk party, they will usually be charged a low interest rate; if the borrower is considered high risk, the interest rate that they are charged will be higher.

Interest is charged by funders as compensation for the loss of the asset’s use. In the case of lending money, the lender could have invested the funds instead of lending them out. With lending a large asset, the lender may have been able to generate income from the asset should they have decided to use it themselves.

Interest cost is the cumulative sum of the amount of interest paid on a loan by a borrower. This amount should include any points paid to reduce the interest rate on a loan, since points are in effect pre-paid interest. Additionally, any negative points or rebates paid by a lender to a borrower should be subtracted from the interest cost as they are in effect a refund of future interest the borrower will pay on the loan.

Interest cost is one measure of loan economics. However, other measures such as lender fees and loan closing costs, tax benefits and consequences, principal reduction, and opportunity costs in the form of re-investment rates should also be included in a thorough analysis of loan choices.

Cost of funds is the interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one of the most important input costs for a financial institution, since a lower cost will generate better returns when the funds are deployed in the form of term loans to borrowers. The spread between the cost of funds and the interest rate charged to borrowers represents one of the main sources of profit for most financial institutions.

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