Interest means the reward for the use of capital.

It is also called as the income of the owner of capital

for lending it. According to Keynes “Interest is the reward for parting with the liquidity for a specified
period.” Mill said ‘it is the remuneration for abstinence” which means it is a reward for saving.

Concepts of interest

A. Gross Interest

Gross interest refers to the entire payment made by the borrower to the lender on certain amount of
loan received for a period of time. It includes not only the payment made for the use of money but
also for the risks, inconvenience and management. It includes the following:-

1. Net interest – it is the payment for the use of capital or money only during a particular period of
time.

2. Compensation for risk taking- The lender exposes him to different types of risks when he lends
money. Such risk arises due the fact that the borrower may not be able to pay back the money. Every
loan which is not fully secured contains an element of risk of non-payment and so the lender must be
compensated for it. Two types of risks are:-

Personal risk- Arises due to the reliability and creditability of the borrower.

Trade risk- Arises due to the unpredictable fortune of the venture in which borrower has invested
the borrowed capital.

3. Wages of management- These refer to the incidental expenses which a lender has to bear on
keeping proper books of accounts of the borrower and attending other legal formalities.

4. Compensation for inconvenience- When a lender loans his money he forgoes its use for the
duration of loan. His money is locked up and cannot be used for more profitable purposes. So the
lender seeks compensation in the form of high rate of interest.

Gross interest = Net interest+ Risk bearing + reward for management of funds+ reward for
inconvenience.

Apart from other factors it also depends upon the demand and supply of money.

B. Net Interest

Net interest refers to the payment for the use of money capital only.

According to Chapman,” Net interest is the payment for the loan of the capital when no risk, no
inconvenience and no work is entailed to the lender”.

Net interest = Gross Interest - (Reward for the risk + Reward for management + reward for
inconvenience)
Causes for difference in rate of interest

A large number of interest rates prevail in the money market. Different interest rates are charged
on different types of loans because of the presence of monopolistic competition among the
lenders. Rate of interest differs due to the following reasons:-

Ø Differences in maturity period- long term loans carries higher rate of interest as compared to short
term loans because the lender has to suffer greater inconvenience if he has to wait for long time to get
back the principal amount along with the interest.

Ø Amount of loan – as the cost of debt management remains the same for the small or large loans so
rate of interest stands in an inverse relation to the amount of loan.

Ø Liquidity of the security- Rate of interest also varies with the degree of the liquidity of the assets
offered as security against the loan. The liquidity of these securities implies the ease with which they
can be converted into cash by the lender. The greater the liquidity of the assets offered as security
against the loan the lower will be the rate of interest and vice-versa.

Ø Differences due the distance- People are willing to invest their capital at a lower rate of interest in
venture at shorter distance as it becomes easier for the lender to monitor the loan.

Ø Purpose of the loan- it is often been observed that the lender (say, banking institutions) charges
relatively higher rate of interest on loans for purchasing luxury consumer goods. Whereas lower
interest rates are charged on the loans flowing to the priorities sector (Say, loans given to the farmers).

Ø Credit-Worthiness of the Borrower- Interest also depends on the credit standing of the borrowers.
Persons of known integrity can get loans on easy terms.

Ø Differences in productivity- For highly productive ventures, people will be to borrow even at a
high interest rate.

Ø Market imperfections- The monopoly or oligopoly elements in the financial market make it
imperfect in nature. Thus the money lenders in small towns or villages have few competitors and
hence charge relatively higher rate of interest. While there are many competitors in an organized
urban money market and so the charges lower rate of interest.