Interest
From Encyclopædia
Interest is a sum of
money paid for the use of another amount of
money, called the principal. Banks and other financial institutions pay interest to savers for the use of
money deposited in savings accounts; borrowers pay interest for the use of
money loaned to them. Interest is sometimes referred to as "carrying charge," "finance charge," "time-price differential," "terms," and "credit charge." Interest is usually stated as a yearly rate or percentage of the principal involved. Thus a savings deposit may earn 6% interest a year, or the interest charge on a loan may be stated as 12% a year.Interest was regarded with disfavor from very early times.
Aristotle labeled it an evil practice, a view that persisted through the
middle ages; religious and secular laws prohibited interest, or
usury as it was called. With the
growth of commerce and the development of banks,
usury came to be viewed merely as exorbitant interest, and governments began to set limits on interest rates.SIMPLE AND COMPOUND INTERESTInterest is calculated in two different ways: as simple interest and as compound interest. Simple interest means that the interest payment for the year is the principal amount multiplied by the interest rate; for example, the interest on $1,000 is $60 if the interest rate is 6%. Most borrowing, lending, and saving, however, uses compound interest. When compound interest is computed, the basic one-year period is divided into smaller periods, and the interest earned in each shorter period is added to the principal amount. Since the principal amount becomes larger throughout the year, the total amount of interest paid for the entire year is larger under compound interest than it would be if calculated by a simple interest rate.Interest is usually compounded on a semiannual, quarterly, monthly, or daily basis, which means that earned interest is added to the principal at the end of every six months, every quarter, every month, or every day. For convenience, the interest rate is often stated as a nominal rate compounded at specified periods: 6% compounded monthly, for example. The effective rate, however, is higher than the nominal rate. The effective rate, or the rate actually paid, is illustrated in the following example using a $1,000 deposit that receives 6% interest (the nominal rate) compounded quarterly.Principal (1st quarter) $1,000.00 + $15.00 interest (1st quarter)Principal (2d quarter) $1,015.00 + $15.23 interest (2d quarter)Principal (3d quarter) $1,030.23 + $15.45 interest (3d quarter)Principal (4th quarter) $1,045.68 + $15.68 interest (4th quarter)Principal (at the end of the year) $1,061.36$61.36 total interest for the year = 6.136% of original ($1,000) principal.The effective interest rate in this example is 6.136%. If the rate were 6% compounded daily, a principal sum of $1,000 would earn $61.83 in a year, and the effective rate would be 6.183%. The following formula may be used for calculating effective rate of interest:P(1 + r)(to the nth power) - PE = ------------------------------- X 100Pwhere E = effective rate of interest; P = original principal; r = rate of interest per time period; and n =
number of time periods. the effective rate, therefore, for $1,000 at 6% interest compounded quarterly is:1000(1 + .015)(to the 4th power) - 1000E = ---------------------------------------- X 100 = 6.136%1000In some
cases interest is discounted at the beginning of the loan period, meaning that it is deducted from the principal. On a discounted loan of $100 at 6%, the borrower receives only $94; thus paying $6 for the use of $94, or approximately 6.4% interest.GOVERNMENT REGULATIONBecause interest rates influence the level of economic activity by affecting the ease with which
money may be borrowed and the incentive for saving, governments frequently regulate interest rates. In the
United States, the federal government regulates interest rates indirectly through a variety of agencies. The most important of these, the
Federal Reserve System, influences interest rates by controlling the discou?t rate, which is the interest rate charged banks that borrow from the Federal Reserve banks; by setting reserve requirements, which fix the maximum ratio of loans to deposits for many commercial banks; and by controlling margin requirements, which stipulate the amounts that investors can borrow in order to buy or hold securities. Other federal agencies, or federally sponsored organizations active in the
mortgage market, affect interest rates by buying and selling
mortgages, by guaranteeing or insuring loans, and by making funds available to savings and loan associations and other lenders. Among these institutions are the [[Federal National
mortgage Association|Federal National
mortgage Association]] and the DEPARTMENT OF VETERANS AFFAIRS. Farm credit is affected by agencies under the supervision of the FARM CREDIT ADMINISTRATION. In 1990, Congress undertook new legislative initiatives in the area of home
mortgages including the creation of a National Homeownership Trust.The Board of
governors of the
Federal Reserve System also administers the Truth-in-Lending Act, designed to inform borrowers about the cost of credit. The act, as embodied in Federal Reserve Regulation Z, requires that the total finance charge (which may include interest, insurance premiums, credit report fees, and other fees) and the annual percentage rate must be disclosed to the borrower before credit is extended.The act covers all credit used for personal, family, or agricultural purposes not exceeding $25,000, and all real estate transactions (including home equity loans) by individuals or for agricultural uses. Most states have
usury laws that specify the maximum interest rate that may be charged on loans or (sometimes)
sales of merchandise in which payment is delayed. The
usury rate varies from state to state.INTEREST AND THE ECONOMYThe interest rate--the cost of borrowing
money--has a profound effect on the performance of the economy and (in the
case of U.S. interest rates) may also influence the well-being of foreign economies. U.S. interest rates climbed to record heights in the period between 1979 and 1982, for example, attracting great quantities of foreign capital, which deprived those economies of investment funds. Western European economies in particular suffered from slow
growth rates during that period, at least in part due to high U.S. interest rates. The U.S. economy experienced higher costs for
mortgages and business expansion, helping to precipitate the 1981-83 recession. The high value of the dollar that resulted from the high interest rates also provoked the worst balance of trade deficits in the country's history, as the cost of imports dropped and the cost of U.S. exports rose sharply. It was not until the Federal Reserve backed away from its anti-
inflation policies (see
MONETARY POLICY) that interest rates began to fall and business activity grew stronger.Interest rates crept up again as the 1980s ended, and
fears of resurgent
inflation motivated Federal Reserve policies. A general slowdown of economic
growth, higher oil prices, and tax changes designed to reduce the federal
budget deficit contributed to a recession in 1991 and renewed
pressure on the Federal Reserve to lower interest rates. While U.S. interest rates were lowered, and the value of the dollar fell, rates in other important economies remained high. The Bush administration, concerned that high rates overseas could choke off U.S. export markets, advocated lower rates, especially in European countries.
William W. CurtisBibliography: Bryant, R.C., Controlling
money: The Federal Reserve and Its Critics (1983); Burger, A.E., The
money Supply Process (1971);
Homer, S., A History of Interest Rates (1977); Mark, J., An Analysis of
usury (1980); Patinkin, D.,
money, Interest and Prices, 2d ed. (1989).
