Interest

Financial Dictionary -> Loans -> Interest

Interest is the practice of assigning a fee on credit and other borrowed assets on top of the principal borrowed amount, thus making a profit on the loan. It is common place with all types of credit issued by banks and other financial institution, applying to loans, mortgages, credit cards, overdrafts and so on.

The reasoning behind interest is not just to make a profit, but to also hedge the opportunities that could have arose by using the money to invest elsewhere. It is usually calculated as a percentage of the borrowed amount, based on current rates.

Interest rates can be fixed or variable. With a fixed rate of interest it is easy to calculate the total amount due. For example if Bob borrowed $50,000 and the rate was 5 percent he'd ultimately pay $2,500 in interest over the term of the loan. However it is common for financial institutions to use variable rates, which can be changed in line with the economy. Both have their advantages and disadvantages for both parties. A bank would probably want to lock in a high fixed rate, whereas a borrower would want to lock in a low fixed rate. Of course what constitutes a low or high rate can change before the maturity date.

Most bank accounts also pay a lower rate of interest to account holders for investing their money in to the account. Technically all bank accounts are an investment and can collapse along with the holder's savings. It is estimated that only 10% of people could actually withdraw all of their funds if everybody went on a bank run.

Critics of interest claim it is illegal and mathematically impossible to sustain. According to modern money mechanics banks can lend around ten times the amount they have in deposits, and thus are charging interest on something that never existed, depleting the money supply. Eventually somebody somewhere loses. Banks have also been criticized for causing the subprime mortgage fiasco by lending money too easily and then increasing interest rates, causing defaults and physical wealth to be pooled in to the banks, leaving thousands homeless.