Interest in finance, is a surcharge on the
repayment of debt (borrowed money). Interest is justified
in capitalist countries by one
or more of the following:
- the time value of
- the opportunity cost of
- macroeconomic price changes (inflation)
Mathematically, interest generally falls in one of the following two
- simple interest, in which outstanding balances grow
linearly with time. In each period, the total balance grows by some fraction
of the principal (that is, of the original investment).
- compound interest, in which outstanding balances grow
geometrically with time and exponentially with time in the limit as the rate
of compounding becomes instantaneous. In each period, the total balance grows
by some fraction of the sum of the principal and the interest paid on all
In either case, the fraction by which the balances grow is called the interest rate.
Simple interest is seldom used in practice. In most cases this is because the
interest earned in previous periods is assumed to remain in the
account. Only when the interest earned is immediately withdrawn
from the account should simple interest be used. When interest is
not collected as it is accrued (as with a certificate of deposit,
where the payment is in a lump sum), the interest increases the
amount of money subject to interest. In this case simple interest
would produce mathematically inconsistent results. In compound interest,
how often it is compounded changes the amount of interest.
Economists sometimes referred
to interest as rent on money. As with any
rental, the market price (or rate) is subject to change to reflect
market conditions. Interest rates
are very closely watched market indicators, and have a dramatic
impact on finance and economics.
Interest involves the future, which is uncertain. Some
interest bearing investments are riskier than others. The greater
the risk of the security, the more interest investors expect to receive.
Different parties will be offered different rates on debt obligations (such
as loans). The measure of credit worthiness of an individual is called a credit
rating or credit score. Other
entities (such as governments and companies) will acquire a bond rating if they are
active in bond markets.
The collection of interest is prohibited by Islam which results in a special
type of Islamic banking. Gesell
researched the destabilizing effect of interest (an asset will increase
beyond any limit over time) in his Freiwirtschaft theory,
which includes negative interest rates.