What is Interest?

Table of Contents

Interest refers to a certain amount of money paid on borrowed capital. It is the payment made for using money of another, which is the borrowed money. It is the price paid for the productive services rendered by capital.

It is the cost of finance for borrowing and it is the revenue from lending money, for the lender. Interest is the monetary charge for borrowing the money which is expressed as an annual percentage of the principal value.

Interest is in direct proportion to risk, higher the risk is, higher would be the rate of interest. It is determined by various factors like money supply, financial policy, the volume of borrowings, inflations.

Interest is an obligation against the profits of the business. It is a fixed payment which needs to be paid irrespective of the company makes profits or not. Company has to make payments, if it has borrowed money from creditors like debenture holders, deposit holders, bond holders, etc.

TERMINOLOGIES:

PRINCIPAL: Principal amount refers to the amount which is actually borrowed by the borrower. The principal is the base amount on which the interest is calculated. It is denoted by P.

TENURE: Also known as period, it is the time-line for which the money is borrowed. It is represented by n.

RATE/ PERCENTAGE: Rate is a measuring tool, it is the way to calculate the interest payable on the principal value from period to period. It is denoted by r.

INTEREST: Interest refers to the amount which is paid on the principal value by the borrower to the lender. It is the cost of renting money.

TOTAL AMOUNT: The summation of the principal and the interest is known as the total amount, which is the maturity value. It is represented by A.

TOTAL AMOUNT = PRINCIPAL + INTEREST

The credit score of an individual play an integral role in the approval of the credit amount. The creditworthiness of the borrower decides the interest payable, loan amount, nature of the loan.

You can calculate the amount of your interest payable using the Simplifiedfiscalaffairs’ EMI Calculator to reach the right conclusions.

How does it work?

The mechanism of the payment of interest is such that, it is the cost of renting money. The term Interest comes under borrowed capital.

When a person has the requirement of a specific sum of money, he takes up the money on credit basis, like, loan, credit cards. The person who lends the money is known as the lender, whereas, the person who borrows the money is known as the borrower. The lender of the money charges a fixed amount of interest on the principal value, for lending the money. The payment of interest is a cost, to the borrower, whereas, income to the lender.

At the end of the period, the principal value is repaid along with the interest money which is known as the total amount. The percentage or rate of interest is directly proportional to the risk associated; higher the risk, higher will be the rate of interest and vice-versa.

FOR EXAMPLE: Financial securities like bonds, debentures, deposits, loans carry a fixed and pre-determined rate of interest.

Determinants:

The rate of interest applicable has many factors associated to it.

The nature of loan.
The tenure to repay the total amount
The creditworthiness of the borrower.
Inflation rates prevalent and the market conditions.
Probable risks associated.
Trade/ business cycles prevalent in the economy.
Money flow in the economy.
Government policies with respect to interest payment rates.
The total amount of the loan.

The Rule of 72:

The rule of 72 in finance, evaluates the time duration, an interest bearing investment would take to double itself. Divide the number 72 by the specific and fixed interest rate to determine the timeline in which it will get doubled.

For example; Divide 72 by 8%, the result will be 9. Therefore, it will take a span of 9 years to double the amount.

Tenure to Double (years) = 72/ Interest Rate Specified

Simple Interest:

The interest which is to be paid on the principal amount only, is known as the simple interest. It is calculated only on the principal amount without the inclusion of interest.

For example; The interest calculated on Rs.100 at 10% after one year is Rs.10 and the total amount is Rs.110.

SI = P ×N × R / 100

Whereby,

SI: Simple Interest
P: Principal Amount
N: Tenure
R: Rate of Interest
A: Total Amount

Compound Interest:

The interest which is calculated on the amount matured in the previous year is called compound interest.

It is an interest which generates further interest. The simple Interest is a strong tool to invest and generate good returns. One must take into consideration the frequency of compounding. The more the frequency the better it is.

The simple Interest generated on the principal amount is added yearly and futher calculated to derive the compound interest.

For example; The compound interest on Rs.100 at 10% is Rs.110 and after two years is Rs. 121.

Compound Interest= Principal + Simple Interest

C.I.= {P(1+ r/100)^n - P}

A = P(1+r/100)^n