How to calculate Interest?

The topic of interest has been a very controversial one. Harold Somers has rightly said, “Few topics in Economics infact have received as varied treatment as has the theory of interest.” Interest is the reward, remuneration and an incentive provided to the moneylender for depriving him of his money for certain period. It is defined as the price for the use of capital. It is the amount paid by borrowers to the lenders for the use of his funds.”

According to Cairn cross, “Interest is the price paid for the hire of loan capital.”

In other words of Dr. Marshall, “Interest is the price paid for the use of capital in any market.” Keynes treats interest as a purely monetary phenomenon.

The rate of interest is normally expressed as a percentage per year on the amount lent. If a blank lends Rs 5000/- to a person at the rate of 10% per year, the total interest payable at the end of the year would be Rs. 5500/-

Gross Interest and Net Interest:

Gross interest is the entire payment made by the borrower to the lender. It refers to the whole of the income received by the lender from the borrower. If the lender receives Rs. 10/- as the interest of a loan of Rs. 100/- this Rs. 10/- is called gross interest. The whole payment is not made for the exclusive use of capital. It is a mixture of other elements as well. Gross interest includes the payment not only for the use of money capital but also for risks, inconveniences and management.

Net Interest, on the other hand, is a part of gross interest. It is that part of gross interest, which is paid exclusively for the use of money capital. Net interest is also known as pure interest. Gross interest constitutes the following items.

1. Reward for risk:

Lending involves a risk. It is not certain whether the lender will get back the money or not. The lender is uncertain as to when the loan will actually be paid back to him. The lender charges an extra amount by the way of insurance to cover these risks. The risks are personal and business. Personal risks arise from the personal character of the borrower.

Business or trade risks arise out of the nature of the trade in which capital is invested. The business itself may be risky. If the business operations are not based on accurate forecasts, the business may fail. There is no guarantee that the lender will get back both the interest and the principle of his loan promptly and without default. Hence, the lender charges an extra amount as an insurance against these risks.

2. Reward for Inconvenience:

The lender after parting with his money is put to certain inconveniences. During the period of loan the lender may himself need money. Non-payment of installments on the due dates also causes inconvenience. There may be necessity of filing a case if the borrower refuses or fails to pay the loan.

3. Reward for management:

The lender will have to engage the services of accountants for maintaining loan accounts. The lender will have to spend considerable money, time and efforts. In this way if the cost of management is more, the rate of interest will be more and vice versa. Thus, gross interest can be summarized as:

Gross Interest = Net interest + Reward for Risks + Reward for inconvenience + Reward for Management.

Net Interest = Gross interest – Reward for risks – Reward for inconvenience – Reward for Management.