What is interest: –
Interest is a price for the use of borrowed funds. The funds are required to buy capital assets for further production. Generally borrowing is made in monetary terms. The borrowing amount is not only spent on purchasing capital goods for production but also a part of it is spent in some other ways. In economics interest refers to monetary interest which is paid for the use of capital only.
Thus interest is the price paid for the use of capital. That part of the fund which is bent to others earns interest only. Thus interest is the income obtained from that part of capital which is used for lending. The rate of interest is normally expressed as percentage per annum. A bank or private person lends Rs, 3000 at 12 per cent.
The total interest received by him is Rs. 360. Some economists have defined interest in different ways. According to Keynes “interest is the payment for parting with liquidity.” According Seligman “interest is the return from the fund of capital. In the words of Mayer “the price for the use of loan able fund is called interest.
Gross interest and net interest:-
Gross interest is the amount paid by a borrower to the lend or an return on capital borrowed. The entire amount he receives “should not be treated an interest as the lender spends some amount for such lending activity. The payment in return of capital is not exclusively made for the use of capital only.
Thus the total interest paid to the lender is the aggregate of other expenses and the price for the use of capital. He, thus, receives gross interest. But when certain elements are deducted from the gross interest, we get net interest or pure interest. Net interest is paid exclusively for the use of capital. In order to calculate net interest the following elements are to be excluded from the gorses interest.
(1) Insurance against risks:-
Lending activity is full of risks. The moment the lender lends money to a borrower, he shoulders certain risks. The lender lones the liquidity of money. There is no certainty of getting back the amount lent to others. He may not be sure of getting back the exact amount in right time. Risks are of two types. Personal risks and trade risks. Personal risks arise due to the personal character and attitude of the borrower.
The borrower may become dishonest or he may become bankrupt due to reckless spending. In such a case he may be unable to pay off the borrowed amount. Trade risks on the other hand, arise owing to the nature of trade or business. If the trade on which capital is invested experiences fall in sale due to fall in demand, the borrower cannot pay off what ever honest and trustworthy he may be. Thus in view of the above risks a lender charges certain extra amount over and above the price of capital as the insurance against risks.
(2) Payment for management:
Lending operation involves management. Before lending a person, he should have certain knowledge about borrower’s motive, financial condition etc.
Records are to be made regarding the borrowers properties, existing stuck of his business on which he intends to invest, different payment. Installments of principal and interact etc. He keeps correspondence to the borrowers and sends reminder in case of default etc. For this purpose he being a single man cannot do all these things. He has to appoint manager and clerks to perform all the above works. For this he pays them salary. Thus the lender charges certain extra amount with interest.
(3) Payment for inconveniences:-
When money is lent to others, the lender will close the liquidity of his capital. He will lose the liberty of spending it at any time according to his will. Thus the lender faces certain inconveniences after the money is lent to others. Capital is formed out of saving when a lender saves he is deprived of consuming worth that amount.
He scarifies the present for the future. He loses the command over his money and all sorts of trouble and difficulties come to his way. Borrowers may not be regular in payment. In the face of rising price and falling value of money, he will lose although he charges interest on the borrowed fund. Thus all these things pose inconvenience for the lender. To compensate all the above inconveniences, the lender charges some extra amount over and above his rewarded for capital lent.
Thus is lending, operation what the lender gets constitute gross interest. In order to arrive at the net or pure interest, the above three types of payments are to be deducted from the gross Interest. Net interest means that part of the gross interest which is exclusively paid for the use of capital. Thus if the rate of interest is 12% then the lender may get only 2 or 3% towards the interest or the payment for the use of capital.
Therefore Gross interest=Net interest return for risks return for inconveniences + return for management of loan.