What is interest?
Interest is paid by a borrower to a lender as compensation for making the amount of borrowed money (the loan) available.
The common way of calculating interest is as a percentage of the amount borrowed – which itself is called the principal. Interest is usually calculated over a period of time (interest per month, per year, etc.). When there is no mention of a period, usually the interest on a yearly basis is meant.
The purpose of interest is to compensate the lender for the risk he or she is taking when lending out the money. After all, the borrower might not be able to pay the money back. As such, you could say it is the pricetag on the trust that the lender gives the borrower when lending out the money. In addition, interest compensates for the fact that the lender can not use the borrowed amount of money for himself.
Types of interest
Interest can be calculated as simple or compound interest. When calculating compound interest, the amount of interest for each period is calculated as a percentage of the total amount of the principal and the interest over the previous periods since the beginning of the loan. With simple interest, the amount of interest to be paid for each period is calculated as a percentage of the principal only.
The Art Reserve Bank uses simple interest. In case you wish to exchange your work of art for Euro’s again, the Art Reserve Bank will give you 10% simple interest on a yearly basis, starting from the day of the original exchange and with the rate the coin was originally exchanged for as principal.
Except for positive rates, interest can also be expressed in negative rates. In that case, interest is called demurrage. When applying demurrage, the amount of money to which it is applied actually becomes smaller as a certain percentage of interest is subtracted. When this concept is applied to a currency, it provides an incentive to spend the money as soon as possible – and thus increase the amount of trade taking place. Throughout history, this principle of demurrage has been succesfully applied in times of economic crises.
Interest in the news
Several interest rates are often mentioned in the news. Most often, the headlines refer to the interest rates used by central banks (see also: Central Banks). The most import interest rate that the European Central Bank works with, is the refinancing rate or repossession rate (refi- or reporate for short). This is the minimum rate that the central bank applies for lending out money to commercial banks. As such, this rate has a big influence on the interest rates that commercial banks ask for lending money to their own customers and other commercial banks – it has a big influence on the ‘price of money’.
Other important interest rates that the ECB uses are the deposit rate and the marginal lending rate. The deposit rate is the rate that commercial banks receive when they place a temporary surplus of money in their account at the central bank. The marginal lending rate is the exact opposite: it is the rate commercial banks need to pay when they temporarily want to borrow money from the central bank on very short notice. Both of these rates are derived from the repo-rate, which lies in between these two rates. Together, the rates form a bandwith of interest rates used by the ECB. Being the lowest, the deposit rate is the ‘bottom’ and the marginal lending rate the ‘ceiling’ of the money market.
The Euribor rate (Euro Interbank Offered rate) is the average interest rate that a certain group of commercial banks in the European Monetary Union applies when they lend out money to each other. This benchmarkrate is strongly linked to the repo-rate. It is also an indicator for the amount of trust that the commercial banks have in each other.
Interest and religion
The practice of interest is probably several thousands of years old. Although interest is charged all around the world, throughout the centuries the concept of interest has often been – and still is – a much debated subject. Depending on the zeitgeist and on religious or cultural viewpoints, in certain groups of people demanding monetary compensation for lending out money is considered completely forbidden or is only tolerated silently.
In the era of the ancient Greeks, Aristotle (384-322 BC) described interest in his work Politics as the most hated and deplorable way to acquire wealth. During the middle ages, charging interest was forbidden for Christians. The Italian poet Dante Alighieri (1265-1321) even declared that a special place in hell was reserved for those charging interest. Jews were also not allowed to charge interest when lending out money to other Jews, but they were allowed to do this when lending out money to non-Jewish people. As a result, many members of the Jewish community fulfilled important roles in the early signings of the ‘financial sector’.
In large parts of the Islamic world, the charging of interest is still considered sinful. The lack of interest is one of the most important characteristics of Islamic banking. Often however, other methods of calculating a certain amount of compensation are applied.
In the wake of the 2008 financial crisis, the debate around the systemical effects of charging interest has drawn renewed attention. The main -extremely simplified- argument against it is that if banks require borrowers to repay the principal and interest by performing some form of economic activity, but then do not spend the interest back into circulation so that it can be 're-earned' with new economic activity, the overall effect is that continuous concentration of money occurs in an ever-decreasing group of people.
Several interest groups are actively campaiging for a study of alternative economic models that do not use interest. For example, the abolishment of interest is an important cornerstone in a model named Mathematically Perfected Economy (MPE). Interestless cooperative banking, such as practiced by the JAK Medlemsbank, is also increasingly popular.