Welcome to You Ask Andy

Linda Gregory, age 16, of Buffalo, N.Y., for her question:

WHY IS INTEREST CHARGED FOR LOANS?

Interest is the price a borrower must pay to a lender for the use of his money. It is one of the fundamental practices of modern business.

Some manufacturers borrow money to buy better machines that will produce a product more efficiently and lower his cost. Or a store owner may borrow money to buy some new items that will attract new customers.

Businessmen borrow money when they do not have cash on hand to make new investments. They are willing to pay interest on their loans because they plan to make a profit with the money, and they believe the profit will more than pay for the interest.

In economic terms, the product that the use of capital goods adds to the marketplace provides the necessary funds, through the economic process, to make the payment of interest possible. The lender is entitled to interest because he gives up, for a time, his right to make the same kind of profit with his money.

Interest is expressed as a percentage. The sum borrowed is called the principal and the percentage paid is called the rate. The rate named covers the use of the principal for one year, not for the total length of time the money is borrowed.

Let's say that you want to borrow $5,000 for four years and the interest rate is six percent. Six percent of $5,000 comes to $300 as interest each year. You will pay $1,200 in interest for the four year period.

Interest paid on only the principal is called simple interest. Interest paid on the principal and the accumulated interest is called compound interest.

Suppose you want to borrow $1,000 at six percent interest compounded annually. You will pay $60 interest the first year and $63.60 or six percent of $1,060, for the second year.

Interest rates vary with different types of loans. Governments can usually borrow money more cheaply than other borrowers, because lenders consider such loans safer than most other loans.

A large corporation with a long record of making good profits can usually borrow money more cheaply than a smaller, unproven company, because the risk is also less.

Rates of interest are usually higher on long term loans than on short term ones, because the lender usually feels that he can foresee the future for a short period, and can take less risk.

When you buy a house, you usually cannot pay cash for it so you take out a mortgage loan and, pay interest on it. You also pay interest when you borrow money to buy a car or when you make department store purchases and pay for merchandise over several months.

 

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