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Nov 18

What is Interest and Why Does it Exist?

by Lachlan Hayes
What is interest blog cover

The term ‘interest rates’ is one of those things that you’ve probably heard a thousand times, and for most Australians, have paid thousands of dollars towards. When it comes time to sign up to a bank, interest rates are one of the major selling points, and rightly so given how great an impact they can have on your finances, but do we really understand how they work or why we have them? Interest rates seem like a complicated topic to learn about; but if they are so important to consider when shopping around for loans or savings accounts, shouldn’t we have a good understanding of their purpose and how they are used and where they come from?

History of Interest

As hard as it may be to believe, interest rates have been around for over 4,000 years with the first recorded examples of lending with interest rates being traced back to around 2000 BCE in Mesopotamia. Back then, humans didn’t use money or cash as a currency as we do today but instead traded crops and animals for other goods. Whilst in this modern era we typically associate interest with money, Mesopotamian farmers back in the day were charging interest to each other long before the first coin was ever forged; and here’s how they did it.

Let’s say that a farmer, we’ll call him James, wanted to produce milk for his family. James had no cows to make him milk so he asked another farmer, let’s call this farmer Peter, if he could borrow his cow. Peter had some cows to spare so he was happy to lend James a cow, however, Peter wanted something in return. He told James that if he were to borrow his cow, he would want more than his cow back in return, essentially interest. “James, I shall lend you my cow on the condition that when you return with my cow you shall also give me 3 hens.” said Peter. James agreed and so interest was born.

Whilst our cash society is far more convenient than carrying hens around in your pocket, the same concept still applies for interest today as it did in the past. Think of the cows as the money you borrow from a bank, and the hens being the interest being charged as you repay the loan; but why does interest exist?

What is Interest?

Put simply, interest is the ‘cost of borrowing’, whether it be the amount you pay the bank to borrow money or the amount the bank pays you when you deposit money with them. When you go to the shop and buy some clothes you pay a price to purchase the clothes and the price is how much the clothes cost. You can think of loans in a similar way, when you go to a bank to get a loan you are essentially “buying” money, the interest rate that you pay on top of paying back the loan is the price of the loan. There are of course a few differences to getting a loan and buying something at the shops, for one, you’ll usually pay for clothes outright instead of over many years like you would a loan, however, the key difference would be that interest rates mean you don’t pay a fixed price. Interest rates are calculated and added onto your balance at a certain frequency which means that there are many things that can change the overall amount of interest you pay on a loan, from how long your loan term is to even how often you make a payment.

Now that we’ve talked about the interest you pay on your loan, there is also the interest that the bank can pay you. Believe it or not, but when you deposit money into a bank account, there isn’t a big vault that your funds sit in waiting for you to withdraw. Instead, banks use your money to lend to other people and for them to have this luxury, they pay you for it each month. Even though this will only be a few dollars a month, every dollar counts when it comes to getting on top of your finances.

Why do Interest Rates Exist?

The biggest reason is to give lenders a reason to hand out their money to people! If you or I were to lend some money to a friend or family member, we might not expect anything extra in return and would be satisfied knowing that we helped out a loved one. On the other hand, if you were to lend to someone you didn’t know that well, you would probably want something extra in return. That’s essentially the same reason banks and lenders charge interest – they could use their money do all sorts of things, so in order for them to lend it out to you and me, they want something in return which is typically charged in the form of interest. Charging an interest rate on the money they lend out means that they can make a bit more money back, which makes them happy to keep lending!

Interest isn’t just for the banks and lenders to make some money though – it also helps to prevent them losing money. Banks and lenders don’t want to give out loans to people that can’t or won’t pay them back because that’s a loss for them. To avoid this from happening, lenders will carefully select who’s loans they approve or decline. However hard they try though, banks and lenders realise that it just isn’t possible to have every single person pay their loan back. So, they charge interest on the loans they give out to their customers – that way if one of their customers fails to pay back their loan, the lender will be able to cover the loss with the interest earned on other loans. This means they won’t go out of business and the responsible types like you and I can continue to borrow from them! This is also one of the reasons why you don’t pay a lump of interest back when you repay the loan, but instead, pay a little more than the minimum repayment each time in interest. Essentially meaning that the bank starts recouping their money from day one.

Who Decides the Interest Rates?

Ultimately it’s the lender or bank’s decision what interest rates they charge on loans or reward on savings, but that doesn’t mean they hold all the power. When banks and lenders decided what their interest rates should be, they have to take into consideration a few different things. Firstly, they have to be able to cover the costs of running the bank such as staff, technology and even the cost if someone doesn’t pay back their loan; otherwise, they won’t be able to exist as a business!

Secondly, their rates have to remain competitive with other lenders in the market. Think about it this way, if most banks are charging 5% on their home loans and one bank decides to charge a massive 40% on their loans so that they can make more money, no one will get a loan from them! This means that they will have to reduce their rate back to around 5% in order to get customers unless they have other features or extras that they can justify a bump in rates with.

In the world of lending, it’s a careful balance of being competitive and building a sustainable business. For lenders with a different perspective (like us), the third consideration is doing the right thing by the customer, so that one day, you can be debt free.

How Does Not Having a Solid Understanding of Interest Rates Present a Risk to You?

So you might be thinking, how does this all of this affect me? For starters, having an understanding of how interest rates affect you could save you money in all sorts of ways. Having a base understanding of interest rates and their purposes puts you in the position of power – you’ll be equipped to shop around for the best products for yourself. And even better, you’ll be able to look into ways that will save you money when you are paying your loan back as a well. Realistically, combining these two skills could help you save thousands of dollars over the life of a loan – not bad when all you have to do to get started is to read this four part mini-series!

Where to from here?

It seems like whenever the TV or radio is turned on, viewers and listeners are bombarded with ads about credit products like personal loans, home loans and credit cards, so it’s good to have an understanding of how interest rates work, making us savvy credit-shoppers. That way we can make more informed decisions for ourselves before blindly signing up to a new credit product.

If you found this blog useful, check out our other blog on interest rates:

• The Different Types of Interest Rates.
Good Interest vs. Bad Interest.
• 6 Interest Myths Debunked!

Disclaimer: Any information provided in this blog is of a general and informative nature only. While all reasonable care has been taken by Pioneer Credit Connect in compiling this information, Pioneer Credit Connect makes no representations or warranties, whether express or implied, as to the accuracy or suitability of the information contained in this blog.