Donít Let Interest Rates Fool You

By: James Monahan


Albert Einstein has referred to interest as the eighth wonder of the world, the greates invention of the human race, and the most powerful force in the universe.

Why is this so? Interest has three major functions in finance. It is the surcharge placed on the repayment of borrowed money or goods; it is the return which is derived from investments; and interest also refers to a personís right or claim to a corporation, such as that of a creditor or owner.

In economics, interest is referred to as rent on money. Rent, or economic rent, is further defined as a payment to a factor of production (land, labor, and capital goods).

Like any other form of rental, interest rates constantly change to reflect market conditions. Interest rate is the percentage by which balances grow, and the initial balance is referred to as the principal. Interest rates have remarkable effects on finance and economics, thus, they are the most watched market indicators.

History suggests that the Sumerian civilization is the first to have developed a structural credit system based on grain and silver, the two main commodities. Before the advent of coins, Sumerians practiced a credit system where loans were made in the form of metals based on their weights.

Loans of grain and silver made trading possible. Silver was used by towns, and the country economies used grain.

As proof to this historical claim, archaeologists have uncovered metal pieces believed to be used in trade in Troy, Minoan, and Mycenaean civilizations. They have also found similar items in Babylonia, Assyria, Egypt, and Persia.

Today, credit has changed into an entirely new system. Banks, individuals, and other financing institutions have developed their own system of collecting interest for the repayment of borrowed money, or debt.

This practice; however, is considered usury by religious orders such as the Jewish and Christian. In Islam, a special type of banking is practiced, which is consistent with Islamic laws, such that the collection and repayment of interest is prohibited. There are Islamic banks which cater to this specific banking system.

Interest accumulates in two ways: by growing linearly with time (simple interest), and by growing exponentially over time (compound interest). Simple interest, the method by which interest accumulate linearly with time, is seldom practiced because the interest earned by the money previously is assumed to have remained in the account.

When this happens, the amount of money which is subject to interest increases because the previous interest remained with the capital money.

With compound interest, outstanding balances, which may include the principal and other add-on amounts, balance grow exponentially through time. This means that periodically, the total balance grows by percentages of the total of the principal and the interest paid in previous periods.

In this mode of interest, the rate of compounding influences the whole amount of interest which is paid over the duration of the loan. The growth function in compound interest is an exponential function with regards to time.

Today, there are two general types of interest rates for debt instruments. Debt instruments are also called income streams, which pertains to the stream of income for the person who lends money.

There are a number of debt instruments such as business-based, collateral-based, consumer-based, contingency-based, government-based, and insurance-based instruments. These interest rates are fixed-rate and variable rate.

Fixed-rate instruments, the more common between the two, have fixed value throughout the instrumentís duration. This interest rate is usually used in bonds.

Variable-rate instruments are typically attached to an index which floats according to the economic conditions such as prime rate (interest rate given by lenders to customers who are considered trustworthy) and CPI or consumer price index (statistical measure of the average of prices of a set of economic goods and services bought by wage earners in urban areas).

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James Monahan is the owner and Senior Editor of InterestBase.com and writes expert articles about interest.

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