In Justification of Interest

April 14, 2010

Interest

It should be unnecessary to justify interest but somehow there are strong feelings against debt and interest. The fact that interest is paid in a free market is a point in its favor. It is a voluntary action between two people and profits both of them or it wouldn’t happen.

However there is the biblical stricture against “usury” We get around that by creative interpretation of “usury”. Islam too has a rule against interest. Muslims make complicated loans which achieve the purpose of paying interest by calling it something else.

Finally, there is the common attitude of sympathy for the borrower and loathing for the “loan shark”. I suppose it is this attitude which produces our bankruptcy laws which leave the lender to take his losses, and free the borrower to borrow again.

Nobody likes to be in debt, but borrowing serves a purpose. For whatever reasons, we sometimes want more cash right now. Borrowing now may carry us through until we can repay the loan. For example:

I have been saving up to buy a new car, and have found my dream car at a bargain. However, I need another $10,000 to buy it. I approach you for a quick loan.

It happens that you have the $10,000 available. You too have been saving to buy a new car. But why should you give up buying a new car now so I can get mine now?

I’m desperate. I offer to pay you back next year with 10% interest. That’s $11.000 next year in exchange for $10,000 now. You agree.

Interest is the price of time.

This is what interest is all about. I’m willing to pay $1,000 so I can buy my dream car right now. You’re willing to wait another year to buy your next car in exchange for an extra $1,000. As in any free market exchange, we each profit in the sense that we each wanted what we got more than what we gave up.

The free market interest rate is determined, like all prices, by supply and demand and competition. At the free market interest rate, the amount of money available to lend equals the amount that borrowers want to borrow. The free market interest rate varies over time to match supply and demand.

The market rate is the basic rate of interest. However, each individual loan has unique circumstances which determine deviations from the free market rate. I borrowed from you at a 10% interest rate, but I could possibly get a bank loan with only5% interest if only my credit rating were good enough. Compensation for risk can be the greatest factor in determining interest on individual loans.

So there are good reasons on both sides of the loan for paying interest. On my part, as a borrower, interest is the price I pay for my impatience. On your part, as a lender, interest is the reward for your patience, plus compensation for the risks. I might default on the loan (I’m reasonably honest). I might die in the next year. You may desperately need that $10,000 sometime in the next year. And inflation may reduce or eliminate the value of the interest you collect next year In fact, that $10,000 could be earning some interest for you if it stayed in your savings account for that year.

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