Interest might seem like the most annoying thing in the world; it increases the cost of loans, causes missed payments on credit cards to skyrocket and makes borrowing money a confusing and somewhat dangerous subject. However, generalizing interest as “bad” is an incorrect misconception; in many ways, interest can be beneficial. This is a topic I will discuss next week.
Now, considering all the harm interest does compared to its relatively minimal benefit, you may be wondering “why does interest exist?”. The goal of this article is to explain the purpose of interest.
This explanation might seem intuitive, but I’ll explore some nuances that’ll make interest even clearer.
Simply put, interest exists because, like any transaction, the goal of the seller is to make a profit. A loan is taken when an individual or company doesn’t have enough money themselves or decides they want to make a purchase without using their own capital. They go to an institution (bank, credit union, etc) and request a loan. In order for the institution to make a profit, the lender (who, in this case, is the “seller” of the loan) charges interest.
I am generalizing here, institutions are not the only ones who charge interest, in fact, when you put money in a savings account or purchase bonds, you too are receiving interest; you are the lender, and the company/bank is the borrower.
Regardless, the more nuanced answer revolves around opportunity cost; a lender could be putting their cash into some kind of investment or asset that could be generating income or providing some kind of return, instead, they choose to lend their cash to someone else. As such, they are missing out on potential profit, and to make up for this missed profit, they must charge interest.
For instance, a bank, instead of loaning you money for a house through a home loan, could simply place their money in an index fund, for instance, and make a significant return over the span of 30 years, the typical term of a mortgage. Instead, they are choosing to give you the money, and are missing out on that potential profit.
Furthermore, interest exists to help compensate for the risk a lender takes on when lending their money out. The borrower could simply take all the borrowed money, and disappear, leaving the lender with a massive loss. So, because the lender is taking on the risk of the borrower defaulting on a loan, they demand interest. While this is not the primary reason interest exists, it is certainly one of the central reasons.
So, to summarize, interest exists because a lender must be compensated for lending their money to an individual, rather than investing it somewhere else. The lender, in cases of home and auto loans, can be institutions like banks, in cases like student loans, can be a government, and in cases like bonds and savings accounts, can even be individuals like me and you! In each instance, the lender is taking on some risk, and missing out on the potential for profits elsewhere. So, interest is paid out as a method of making up for those lost profits, and as a fee for the lender taking on such risk.
I hope you found this article informative, and I’ll catch you in the next one!