Debt Dictionary


Investment Dictionary -> Interest

The term interest refers to a fee that is charged by a lending institution for a borrowed sum of money. The interest is typically expressed in the form of annual percentage of the principal. The justification behind interest is that the lender should be compensated for missing out on other investments that may be made with the issued loan. Here, opportunity cost stands for the next best alternative as a result of the investment choices. In brief, the foregone investment option represents opportunity cost for the lending institution.

Consumer goods, money, and shares may be lent for a corresponding interest. In general terms, the amount of the borrowed sum is referred to as the principal. The fee, in the form of percentage of the principal, is called interest rate. Several types of interest can be differentiated. Simple interest is computed over the original principal or the amount which remains due. The calculation of the following periods does not include accrued interest from past periods. Two possible complications appear with offers that involve simple interest. Firstly, the time value of money renders comparison difficult, if one looks at two identical rates at different time periods. Secondly, the unpaid interest turns into interest payable. In this case, it transforms from simple interest into compound interest. The latter should be calculated on the original principal for each period, including interest accrued during past periods. The interest may be specified as an annual rate. However under the compound interest, the borrower is required to pay interest on the previous interest.

Furthermore, credits typically include other types of payments such as charges and fees. The annual percentage rate covers the yearly interest rate, including any fees and other expenses. Finally, some loans include unchangeable interest rate referred to as fixed interest rate. Other loans are based on a reference rate which remains outside the control of the lender and the borrower. Such changeable rates are known as floating rates.

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