Posts Tagged ‘interest rate’
What is Usury?
Usury (from the Latin usus meaning “used”) was defined originally as charging a fee for the use of money. This usually meant interest on loans, although charging a fee for changing money (as at a bureau de change) is included in the original meaning. After moderate-interest loans became an accepted part of the business world in the early modern age, the word has come to refer to the charging of unreasonable or relatively high rates of interest.
Usury laws are state laws that specify the maximum legal interest rate at which loans can be made. This makes most loansharking, another name for usury, illegal. Often, loansharks use illegal “scare” tactics to ensure that the lent money is paid back.
Usury (in the original sense of any interest) is scriptually and doctrinally forbidden in many religions. Judaism forbids a Jew to lend at interest to another Jew. It’s forbidden in Islam. The most recent Catholic teaching on usury is by Pope Benedict XIV in his Vix Pervenit from 1745 which strictly forbids the practice, though many Jews, Catholics and Muslims break their own laws in this matter.
While Jewish law forbids the charging of interest to another Jew, Jews are not forbidden to charge interest on transactions to non-Jews. Throughout history, the interest attached to loans by Jews to non-Jews is widely considered to have been a central issue in causing a perception of usury, and contributing to a climate of anti-Semitism: Forceful confiscations of property, and discrimination toward Jews in business practice. Ethnic-based distinctions surrounding the application of interest charges are often perceived as pronounced, discriminatory and unjust, and can inflame existing ethnic divisions.
Usury has been denounced by almost every major spiritual leader and philosopher of the past three thousand years. Plato, Aristotle, Cato, Cicero, Seneca, Plutarch, Aquinas, Jesus, Mohammed and Moses are just a few.
Cato in his De Re Rustica said:
“And what do you think of usury?”
“What do you think of murder?”
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What is Interest Rate?
An interest rate is the “rental” price of money. When a resource or asset is borrowed, the borrower pays interest to the lender for the use of it. The interest rate is the price paid for the use of money for a period of time. One type of interest rate is the yield on a bond.
When money is loaned the lender defers consumption (or other use of the money) for a specific period of time. The lender does this in exchange for an expected increase in future income. The expected increase in real income (relative to the amount loaned) is the real interest rate. Note that the real interest rate is calculated by adjusting the actual rate charged (known as the money or nominal interest rate) to take inflation into account. (See real vs. nominal in economics.) A first approximation for the real interest rate for a one-year loan is:
-
- ir = in — pe
where:
- in = nominal interest rate
- ir = real interest rate
- pe = expected or projected inflation over the year.
After the fact, there is the realized or ex post real interest rate:
-
- ir = in — p
where p = the actual inflation rate over the year.
Thus, if the (expected) inflation rate is 5% and the nominal interest rate is 7%, the (expected) real interest rate is 2%.
If financial markets have adjusted for the effects of expected inflation and the real interest rate is given, then the nominal rate approximately equals:
-
- ir + pe
Thus, if the real interest rate is 3% and the inflation rate equals 5%, the nominal interest rate = 8%. The theory of rational expectations is sometimes applied to say that this equation applies in most cases. Most economists would agree that it applies over several years, as financial markets adjust: higher inflation leads to higher nominal rates, all else being equal.
Irving Fisher proposed a better approximation of the relationship between nominal interest rate, inflation and real interest rate. For a one-year bond, the expected real rate equals
-
- ir = [(1 + in)/(1 + pe)] — 1
Using the first numerical example above, the expected real rate equals [1.07/1.05]-1 = 0.19 or 1.9%, which is similar to (but not the same as) the 2% calculated above.
When comparing different interest rates on different kinds of loans, a different kind of formula is used. For the nominal rate on a single type of asset,
- in = i*n + d + mrp + lp
- i*n = the nominal interest rate on a short-term risk-free liquid bond (such as U.S. Treasury Bills).
- d = default premium (reflecting the likelihood of default by the borrower)
- mrp = maturity risk premium (risk factor for length of borrowing period)
- lp = liquidity premium (reflecting the perceived difficulty of converting the asset into money and thus into goods).
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What is Interest?
In finance, interest is a surcharge on the repayment of debt (borrowed money). The fact that lenders demand interest for loans in capitalist countries can be explained by one or more of the following:
- time preference
- the time value of money
- the opportunity cost of money
- macroeconomic price changes (inflation)
- the risk of default on the loan (bankruptcy)
Mathematically, interest generally falls in one of the following two categories:
- simple interest, in which outstanding balances grow linearly with time. In each period, the total balance grows by some fraction of the principal (that is, of the original investment).
- compound interest, in which outstanding balances grow geometrically with time and exponentially with time in the limit as the rate of compounding becomes instantaneous. In each period, the total balance grows by some fraction of the sum of the principal and the interest paid on all previous periods.
In either case, the fraction by which the balances grow is called the interest rate.
Simple interest is seldom used in practice. In most cases this is because the interest earned in previous periods is assumed to remain in the account. Only when the interest earned is immediately withdrawn from the account should simple interest be used. When interest is not collected as it is accrued (as with a certificate of deposit, where the payment is in a lump sum), the interest increases the amount of money subject to interest. In this case simple interest would not reflect the opportunity cost that the lender experiences. With compound interest, the frequency of compounding influences the total amount of interest paid over the life of the loan. An interesting note from mathematics is that the formula for calculating continuously compounded interest, namely
is the same as the formula for calculating e, an important mathematical constant and the base of the natural logarithm.
Economists sometimes referred to interest as rent on money. As with any rental, the market price (or rate) is subject to change to reflect market conditions. Interest rates are very closely watched market indicators, and have a dramatic effect on finance and economics.
Interest involves the future, which is uncertain. Some interest bearing investments are riskier than others. The greater the risk of the security, the more interest investors expect to receive.
Different parties will be offered different rates on debt obligations (such as loans). The measure of credit worthiness of an individual is called a credit rating or credit score. Other entities (such as governments and companies) will acquire a bond rating if they are active in bond markets.
The collection of interest was forbidden by Christian and other religions under laws of usury. This is still the case with Islam which results in a special type of Islamic banking. Gesell researched the destabilizing effect of interest (an asset will increase beyond any limit over time) in his Freiwirtschaft theory, which includes negative interest rates.