The definition of interest is extremely important in today’s business environment where lending and borrowing money are the power stations of our economy. A widespread definition of interest from a borrower’s perspective is “the cost of using someone else’s money”. We talk about interest only in relationship with debt.
But what is the definition of interest from a lender’s point of view? Well, in this case, the sum of money he/she receives as interest is money he/she didn’t work for. But there are more people who owe interest than people who earn interest.
To earn interest you have to either enter in the banking and insurance industry or become a financial investor, by investing in bonds, stocks, mutual funds, and other financial products. To become an investor though, you must risk your savings, which are usually made up of your hard earned money. When you earn interest it is said that “money works for you” and debtors offset the amount of interest they owe with the amount of interest they cash in, thus avoiding to pay interest on their loans. In this way, they use other people’s money for free.
In real estate, when purchasing a house through a mortgage, borrowers pay the interest during the life of the loan according to their amortization schedule. The total cost of the loan is given by the annual percentage rate (APR). All commissions and other taxes attached to the loan can also be considered “interest” payments.
But the demand for home loans (or other types of loans) is adjusted through the monetary policy imposed by the Federal Reserve. The key interest rate is probably the smallest number with the greatest macroeconomic impact. The key rate is actually a duet, a pair of rates: the discount rate and the Federal Funds rate. In April 2019, the Fed funds rate has reached a new record at 2.44% but has not exceeded its target rate of 2.5%. The discount rate is at 3% and no changes are expected until 2021. This means that borrowing money comes at a high cost and loans are more expensive than a decade ago.
When loans are more expensive, the real estate market cools down and home buyers look for ways to save more money for a down payment in order to pay a lower interest rate. There are no loans with 0% interest, but there are home loans with 100% financing and 0 down payment. Although the interest rates are high, it is a good time to buy rather than rent, because the property may increase in value in the future, when the rates will be lowered again to stimulate consumption.
One thing you probably haven’t taken into consideration until now is the fact that paying interest is forbidden in some cultures. For example, Muslims don’t pay and don’t charge interest, so they must be very creative when purchasing a house in the USA. For them, a rent-to-own approach is the way to go. Also, Jews don’t charge interest when they lend money to other Jews. Amish people are also absolutely phobic towards debt, borrowing mostly to buy farmland.
You may say that earning interest is desirable, but you are not taking inflation into account. Inflation cancels interest. If you have a bank deposit of $100,000 with 3% interest, and inflation at the end of the year is also 3%, you don’t earn anything. When you earn a 3% interest it means that you get 3 dollars for every $100 invested, but a 3% inflation takes 3 dollars out of every $100. So earning interest is only profitable at rates that cover the devaluation of the currency. The burden is heavier for the borrowers. Inflation can be added to the interest they owe, which results in more working hours consumed for the repayment of debt.
Interest is necessary to accommodate certain peoples’ financial situations and is here to stay. Sometimes it’s good, sometimes it’s bad - it’s up to us to change our perspective and see the glass half full and not half empty. Loans are important financial decisions and without them, we wouldn’t be able to leave anything behind to our children.