Everything about Interest Rate totally explained
Interest is a fee paid on borrowed capital.
Assets lent include
money,
shares,
consumer goods through
hire purchase, major assets such as
aircraft, and even entire factories in
finance lease arrangements. The interest is calculated upon the value of the assets in the same manner as upon money. Interest can be thought of as "
rent on money".
The fee is compensation to the lender for foregoing other useful
investments that could have been made with the loaned money. Instead of the lender using the assets directly, they're advanced to the borrower. The borrower then enjoys the benefit of using the assets ahead of the effort required to obtain them, while the lender enjoys the benefit of the fee paid by the borrower for the privilege. The amount lent, or the value of the assets lent, is called the principal. This principal value is held by the borrower on
credit. Interest is therefore the price of credit, not the price of money as it's commonly - and mistakenly - believed to be. The percentage of the principal that's paid as a fee (the interest), over a certain period of time, is called the
interest rate.
History of interest
Interest is the price paid for the use of savings over a given period of time. In the
Middle Ages, time was considered to be property of God. Therefore, to charge interest was considered to commerce with God's property. Also, St.
Thomas Aquinas, the leading theologian of the
Catholic Church, argued that the charging of interest is wrong because it amounts to "
double charging", charging for both the thing and the use of the thing. The church regarded this as a sin of
usury; nevertheless, this rule was never strictly obeyed and eroded gradually until it disappeared during the industrial revolution. Some scholars think that banking started among Jewish families because of the restrictions of the church.
... financial oppression of Jews tended to occur in areas where they were most disliked, and if Jews reacted by concentrating on money lending to gentiles, the unpopularity - and so, of course, the pressure - would increase. This is that the Jews became an element in a vicious circle. The Christians, on the basis of the Biblical rulings, condemned interest-taking absolutely, and from 1179 those who practiced it were excommunicated. But the Christians also imposed the harshest financial burdens on the Jews. The Jews reacted by engaging in the one business where Christian laws actually discriminated in their favor, and so became identified with the hated trade of moneylending.
Usury has always been viewed negatively by the Roman Catholic Church. The
Second Lateran Council condemned any repayment of a debt with more money than was originally loaned, the
Council of Vienna explicitly prohibited usury and declared any legislation tolerant of usury to be heretical, and the first scholastics reproved the charging of interest. In the
medieval economy, loans were entirely a consequence of necessity (bad harvests, fire in a workplace) and, under those conditions, it was considered morally reproachable to charge interest.
In the
Renaissance era, greater mobility of people facilitated an increase in commerce and the appearance of appropriate conditions for
entrepreneurs to start new, lucrative businesses. Given that borrowed money was no longer strictly for consumption but for production as well, it couldn't be viewed in the same manner. The School of Salamanca elaborated various reasons that justified the charging of interest. The person who received a loan benefited and one could consider interest as a premium paid for the risk taken by the loaning party. There was also the question of
opportunity cost, in that the loaning party lost other possibilities of utilizing the loaned money. Finally and perhaps most originally was the consideration of money itself as merchandise, and the use of one's money as something for which one should receive a benefit in the form of interest.
Martín de Azpilcueta also considered the effect of time. Other things being equal, one would prefer to receive a given good now rather than in the future. This
preference indicates greater value. Interest, under this theory, is the payment for the time the loaning individual is deprived of the money.
Economically, the interest rate is the cost of capital and is subject to the laws of
supply and demand of the
money supply. The first attempt to control interest rates through manipulation of the money supply was made by the
French Central Bank in 1847.
The first formal studies of interest rates and their impact on society were conducted by
Adam Smith,
Jeremy Bentham and
Mirabeau during the birth of classic economic thought. In the early 20th century,
Irving Fisher made a major breakthrough in the economic analysis of interest rates by distinguishing nominal interest from real interest. Several perspectives on the nature and impact of interest rates have arisen since then. Among academics, the more modern views of
John Maynard Keynes and
Milton Friedman are widely accepted.
Former Central President of the JUP Sahibzada Fazal Karim MNA has stated that the Council of Islamic ideology feels that
Islamic banking ought to be
interest-free by
law.
Types of interest
Simple interest
Simple Interest is calculated only on the principal, or on that portion of the principal which remains unpaid.
The amount of simple interest is calculated according to the following formula:
»
which is less than r if n>1.
Further Information
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