Interest is money paid at a regular rate in exchange for money lent or for delay in paying money owed. Put simply, someone pays interest for the benefit of having possession of someone else’s money.
What Is the Deal with Interest?
The practice of charging interest is common in the financial industry for several reasons.
A foundational principle of interest is the concept that money now is worth more than money later. A person in actual possession of money also has immediate power and access to goods and services within our economic society. By way of example, if Gopi has a large sum of money now she can buy a car now and use it for work or enjoyment now, instead of having to wait months or years to save up for such a purchase. The car itself likely gives Gopi easier access to work and, if she uses her car to make sales, greater income opportunities. As another example, if Saul has one thousand dollars now, he could invest it in the stock market, in real estate, or some other venture and potentially grow that $1,000 to $1,100 in a few months.
By contrast, if a person lends money to someone else who cannot pay it back for six months, this lender has given up the opportunity to use such money for a thing or service of value or to grow that money through investments. By paying the lender interest, however, the borrower gives the lender something in exchange for the lender giving up access to these funds. By charging interest, the lender can recover the value of having access to the money. When the borrower repays the loan with interest, the lender is made whole, because the lender has the initial funds lent as well as a stand-in for the value of having those funds accessible for a period of six months.
Put another way, the borrower pays interest to the lender in exchange for the value the borrower receives for having access to the lender’s money and all this money’s power over a period of time.
This economic principle is known as the time value of money, and interest is basically the quantification of this principle.
The actual rate of interest represents the value of money lent or owed over time. If the economy is strong, interest rates may be higher because the potential growth for investments is higher. In a sluggish economy, interest rates may be lower because the potential growth is lower. If an investor knows she can grow $1000 by five percent in a few months, she may not lend the money at a lower interest rate, not without other incentives.
In addition to representing the potential rate of return on investments, interest rates may be used to stimulate certain behaviors. On a larger scale, for example, lowering interest rates can have the effect of boosting the economy, because it encourages people to borrow money for large spending. If interest are high, on the other had, consumers pay more for their loans and can afford less on their credit.
The rate of interest can be used as an incentive to pay a debt faster. For example, Colorado sets the statutory interest rate for child support debts higher than the statutory interest for other debts. Child support is intended to be used to support children. By setting a higher interest rate on child support, state legislators clearly value the financial support of children greater than other debts. A higher interest rate also incentivizes payment of this debt faster than other debts. Childhood is short, and children grow quickly. Their need for food, housing, clothing, et cetera cannot wait. If a child support debt goes unpaid, the obligor must pay a high premium for the luxury of delaying payment, and the obligee ultimately receives a premium to compensate for the sacrifices of making ends meet for the child on his or her own. The premium paid for late child support payments in Colorado is interest paid at 12% of the amount owed, compounded monthly.
Ultimately, many factors can be considered when setting interest rates, including the risk of default or bankruptcy, the current rate set by the Federal Reserve for federal funds, the stock market, consumer protection laws, and whatever else the lender may need as incentive to let that money go for a time. The rate of interest is set either by agreement of the parties (the lender and borrower) or by law.
How Is Interest Calculated?
The calculation of interest depends upon the type of interest involved. First, a few definitions:
- Principal:
- The original amount of money borrowed, financed, or owed.
- Interest Rate:
- The amount of interest paid per period (day, month, or year) divided by the principal balance. It is usually expressed as a percentage.
- Simple Interest:
- Interest calculated solely based upon the principal balance of the debt at the interest rate set by agreement or by law.
- Compound Interest:
- Interest calculated similarly to simple interest, except that the interest will periodically (daily, monthly, or annually) get added to the principal. This means that the unpaid interest will also begin to accumulate interest at the end of every period (daily, monthly, or annually). Compound interest can cause a debt to grow significantly if payments covering the interest are not made regularly.
For example, in a simple interest calculation, if an individual incurs $12 in interest over the course of one year on a principal balance of $100, the annual percentage rate (APR) of interest is 12%. Interest set at an annual percentage rate rarely incurs once per year; rather, lenders typically calculate an annual percentage rate of interest on a monthly or even daily basis. If calculated on a monthly basis, the 12% annual interest would accumulate at a monthly rate of 1%. If calculated on a daily basis, the 12% annual interest would accumulate at a daily rate of 0.033%.
By contrast, if a $10,000 loan is subject to 12% annual interest compounded monthly, the interest accumulated each month gets added to the principal and also accumulates interest the following month. The first month’s interest of $100 would be added to the principal and interest in the second month would be calculated on a principal balance of $10,100. The second month’s interest would be larger at $101, and at the end of the second month, the principal balance would grow to $10,201 to accumulate interest in the amount of $102.01 in the third month, and so on. Assuming no payments are made over the course of the year, the interest incurred each month would grow larger as the principal balance grows.
The math can get complicated, particularly when payments are made periodically and especially when payments are made irregularly. Fortunately, Legal Thunder’s Interest Calculators can do the math for you.
What Interest Rate Applies?
Typically, the terms of the loan or contract entered into when the debt was established determine the applicable rate and type of interest. Many states have laws which limit the rate of interest which can be charged to a statutory maximum, known as the usury limit.
Additionally, if the terms of a debt are silent on the question of interest, the rate and type of interest may be determined by state law. State default rates of interest are known as the legal rate or the judgment rate. Some states have a default interest rate for different types of debts. Colorado, for example, has a higher default rate of interest for child support debt (12%) than it does for other judgments (8%).
If you have a question about what rate and type of interest applies to your debt, first review the terms of the debt agreement or contract currently in effect. You may want to speak with an attorney to understand the terms of your debt, the applicable interest, and your rights.