In common language interest is a payment made by a borrower to the lender for the use of money usually stated as per. cent per year. But economics interest is defined differently by different economists. According to wick sell interests is “a payment made by the borrower of capital by virtue of its productivity as a reward for his abstinence.” According to Keynes interest is a monetary phenomenon.
It is the reward for parting with liquidity. The whole amount paid by a borrower to the lender for the use of borrowed fund is known as interest. A lender who receives interest not only receives rewards on capitalize but also rewards for other factors. The payment which is paid exclusively for the use of capital is known as net interest.
Net interest is otherwise known as pure interest. Thus Gross interest is a wider concept in which net interest is a part. Besides net interest Gross interest includes many elements. There elements are reward for risk taking wages of management and payment for inconveniences.Net interest is a payment for the loan of capital, when no risk, no inconveniences and no work is entailed on the lender.
Net interest=Payment for the use of capital
Gross interest=Net interest + reward for risk + reward for inconvenience + reward for management.
Difference in interest rates:
The rate of interest at which supply of and demand for capital interest each other is known as equilibrium rate of interest. This is single uniform rate of interest prevailing in the market. But what is seen in the market that are various rates of interest prevailing in the market. Different borrowers pay different interests on the loan. Some pay higher interests than others.
Thus in the market we find a number of interest rates centering round the equilibrium rate of interest. The rates vary from person to person from place to place and from time to time. Interest rate may be different for different borrowers. For example a big industrialist gets loan at a very nominal rate whereas a farmer has to pay a very high rate of interest on the borrowed amount.
It may be seen that rate of interest income part of country is higher than the other parts. It. also varies with time a long term loan fetches a very nominal rate of interest where as short term loans or borrowing claims a higher rate of interest. Below are discussed some of the important causes for the differences in the rates of interest.
(i) Difference in risks:
Interest rates differ due to the difference in risks involved in various investments. Lending always involves risks. The degree of vary in different investments. When a loan is advanced the lender can’t be sure of a smooth and timely repayment of interest d principle. The risks may be personal or trade. A man may become poor due to misconduct and prodigality. He wills not eligible repay the borrowed amount on the other hand due to fall in and the trade may suffer losses. In such a case the business n in spite of his honesty and worthiness may not able to repay, us the greater risk involved the higher will be the rate of interest the less the risk the lower will be the rate of interest. Thus gross interest is higher loss depends on the risks involved in the investment in which money is utilized.
(2) Differences in Distances:-
Rate of interest may vary in two different places because of the distance. Lenders may fear to lend in different distant places because of the psychological fear of non-repayment. That is why mobility of capital is inhibited. This results in over supply, of loan able funds in some areas and in some places there will be scarcity supply of capital. Thus the rate of interest will be naturally high in the area where capital fund is short. Thus on the basis of supply and demand conditions rate of interest varies.
(3) Duration of Maturity:-
The length of period or duration of loan (term) also affects rate of interest. The rate of interest charged on short term lending or long term loan. The Govt, of a country borrows loans for a longer period with a view to boost up economic development. In such a loan the Govt, avails of the loan with higher interest. But loans for duration of one year or some months carry a lower rate of interest.
4. Liquidity of Security:-
A Loan is advanced against some securities. These securities may be either more liquid or less liquid. Liquidity means shift ability without loss. A financial asset that can be converted into cash money quickly and without any penalty is called a liquid asset. This liquidity is also a cause of the differenced in interest rate. The greater the liquidity of an asset, the lower the rate of interest, and the lower the liquidity, the lower the rate of interest. Securities in the form of Govt bonds and bills of exchange and Treasury bill are highly liquid. As against them, landed property, buildings are less liquid as they can’t be shifted eerily.
(5) Size of loan:-
The rate of interest also varies with the size of the loans. A loan of a smaller amount carries lower of interest than the loan of a higher amount given the duration and risks involved. For example a vehicle loan up to 2lakhs carries 18% of rate of interest but up to 4 lakhs the rate of interest is 20%.
(6) Productivity of Capital
Interest rate varies with the productive of capital. If the marginal productivity of capital is high, the rate of interest will higher.
(7) Tax treatment:-
Rate of interest on different types of loan also depends on the exemption tax. For example some bonds floated by gout and other put enterprise allow income tax exemption. In such a case the rich people buy bonds (lends) even at a lower interest rates. Then a rich man having larger income prefer 5% per cent interest rate on tax-exempt bond to 10% present interest rate on a bond of a private company.