Tuesday, July 14, 2009

what is interest?

When a bank or other financial institution lends you money, it requires you to repay the funds lent (the principal), plus an additional payment called interest. The timing of the payment of interest and principal are negotiable and vary form one loan another. However, virtually all loans (except perhaps loans from close friends or relatives) require some payment in addition to the principal.
The interest rate on a loan is the ratio of the interest payment on the loan to the principal amount (the amount borrowed). In other words, it is the cost of borrowing funds as a percentage of the amount borrowed. if you borrow $500 to buy a fancy stereo and pay the money back next year plus $50 interest, you have paid an interest rate of 10 percent, calculated as $50\500= 10%. This example oversimplifies, however. To compare the interest rate on loans with different maturities (such as 1-year and 30-year loans), we need to calculate the interest rate for a given time span. for this reason, interest rates are stated as interest rates per year (the so-called "annual rate of interest' you have probably seen in TV ads or on sign at your bank).the interest rate is the amount over and above the principal amount that is paid in a given year, expressed as a percentage of the principal amount. Also, interest can be indirect.
When you consider interest charges on a loan, you need to realize that interest is charged because funds available for use in the future. This is because people prefer to satisfy their desires today to waiting until later. (Would you prefer to receive a $1,000 gift today or $1, 00 gifts in 30 years?) Borrowers want funds for use today and promise to repay those funds in the future. But a lender requires more than that: A lender requires interest from the borrower's compensation for the lost use of the funds for the length of the loan. In essence, interest is the price of borrowing money. The interest rate expresses this price as the percentage of the principal amount that the borrower pays to use someone else is money. A brief description of how interest payments are structured on some common types of loan contracts follows.

No comments: