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Interest is a fee paid by a borrower of assets to the owner as a form of
compensation for the use of the assets. It is most commonly the price paid for
the use of borrowed money,1 or money earned by deposited funds.2
When money
is borrowed, interest is typically paid to the lender as a percentage of the
principal, the amount owed to the lender. The percentage of the principal that
is paid as a fee over a certain period of time (typically one month or year) is
called the interest rate. A bank deposit will earn interest because the bank is
paying for the use of the deposited funds. Assets that are sometimes lent with
interest include money, shares, consumer goods through hire purchase, major
assets such as aircraft, and even entire factories in finance lease
arrangements. The interest is calculated upon the value of the assets in the
same manner as upon money.
Interest is compensation to the lender, for a)
risk of principal loss, called credit risk; and b) forgoing other investments
that could have been made with the loaned asset. These forgone investments are
known as the opportunity cost. Instead of the lender using the assets directly,
they are advanced to the borrower. The borrower then enjoys the benefit of using
the assets ahead of the effort required to pay for them, while the lender enjoys
the benefit of the fee paid by the borrower for the privilege. In economics,
interest is considered the price of credit.
Interest is often compounded,
which means that interest is earned on prior interest in addition to the
principal. The total amount of debt grows exponentially, most notably when
compounded at infinitesimally small intervals, and its mathematical study led to
the discovery of the number e.3 However, in practice, interest is most often
calculated on a daily, monthly, or yearly basis, and its impact is influenced
greatly by its compounding rate.
According to historian Paul Johnson, the
lending of "food money" was commonplace in Middle East civilizations as far back
as 5000BC. They regarded interest as legitimate since acquired seeds and animals
could "reproduce themselves"; whilst the ancient Jewish religious prohibitions
against usury were a "different view".4
In the Roman Empire, interest rates
were usually calculated on a monthly basis and set as multiples of 12,
apparently for expedient calculation by the wealthy private individuals that did
most of the moneylending.5
The First Council of Nicaea, in 325, forbade
clergy from engaging in usury6 which was defined as lending on interest above 1
percent per month (12.7% APR). Later ecumenical councils applied this regulation
to the laity.67 Catholic Church opposition to interest hardened in the era of
scholastics, when even defending it was considered a heresy. St. Thomas Aquinas,
the leading theologian of the Catholic Church, argued that the charging of
interest is wrong because it amounts to "double charging", charging for both the
thing and the use of the thing.
In the medieval economy, loans were entirely
a consequence of necessity (bad harvests, fire in a workplace) and, under those
conditions, it was considered morally reproachable to charge interest.citation
needed It was also considered morally dubious, since no goods were produced
through the lending of money, and thus it should not be compensated, unlike
other activities with direct physical output such as blacksmithing or farming.8
For the same reason, interest has often been looked down upon in Islamic
civilization, with most scholars agreeing that the Qur'an explicitly forbids
charging interest.
Medieval jurists developed several financial instruments
to encourage responsible lending and circumvent prohibitions on usury, such as
the Contractum trinius.
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