What is Interest? Distinguish between Gross interest and Net interest?
Here we Understand the Concept of What is interest? And what is gross interest and net interest in detailed.
What is Interest? Distinguish between Gross Interest and Net Interest?
First of all we will understand the Meaning of Interest.
Meaning of Interest
In Simple language, the term interest refers to the payment made by the borrower to the lender of the capital for its use. Interest may be paid either monthly, quarterly, half-yearly or yearly. Just as the share of national income accruing to land is known as rent, that of labour as wages, same way, interest is the reward of capital. It means the payment made and received for the use of money.
Interest may also be defined as the 'price' for the productivity or services of capital paid to its owner for his 'waiting' or 'abstinence' which he has undergone in order to save it.
Interest is a purely monetary phenomenon. Professor Keynes defines it as 'the premium which has to be offered to induce people to hold their their wealth in some form other than hoarded money.. it is a reward of parting with the liquidity.'
In all these definitions, the concept of interest is associated with money and therefore it may be said that interest is the payment for the use of money capital.
Now we will discuss about the Gross Interest and Net Interest in detail:
Gross Interest and Net Interest:
The whole of the income received by the lender of capital from the borrowers is known as 'gross' interest'.
Net interest or pure interest is the payment made for the services of capital, while gross interest includes many other items of payment of which net interest is one of them.
Gross interest consists of the following elements. They are as follows:
- Net Interest and Pure Interest: It is the payment made for the loan of a capital.
- Insurance against Risk: Here the lender of the capital undertakes certain type or risks when he lends his money capital to the borrower. A certain amount, therefore, must be paid to him to cover the risk. These risks are of the two types, namely- (a) Personal risk which arises due to the unreliable character of the borrower himself. The lender may fear that the borrower may turn out to be dishonest and refuse to pay back his money and the interest. (b) Trade risk which arises due to the nature of the business in which the borrowed money capital is to be invested. The lender may fear that borrower may lose the money in his trade. There are risks, involved in lending the money capital. Other things remain same and equal, greater the risk involved in a loan, higher will be the rate of interest to cover as an insurance against risk and smaller the risk involved, lower will be the interest rate.
- Payment for Inconvenience: Here, when a lender lends his money capital, he loses command over it for a fixed period. He can't get it back before the expiry of that period. It may cause him inconvenience or loss in two ways. Firstly, he may get back the money even though he may need it most because his money has been locked up for a fixed period of time with the result he may have to borrow from others on interest. Secondly, it is possible that the borrower may return the money at a time when the lender cannot profitably invest it so that the money lies idle and he loses interest. The lender, here, therefore, compensates himself for such losses or inconveniences by charging some thing over and above the net interest.
- Reward for Management: Here the lender has to incur some of the expenditure on the management of the loan. For eg, he has to keep an separate account for every borrower and may have to engage or involve some staff for the collection of interest and instalments of the loan. This results in extra expenditure and the lender compensates himself by charging a certain higher rate of interest.
Net interest is a payment for the loan of capital when no risk, no inconvenience apart from that involved saving and no work is entailed on the lender. This payment is called as pure interest or net interest.
What is interest?
What is Gross interest?
What is Net interest?
Insurance against risk
Payment for inconvenience
Reward for Management
Interest- Meaning of Interest- Gross and Net interest.
Tech writer at NewsandStory
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