Gross Interest Vs. Net InterestFitness Gear & Equipment
Gross interest Vs. Net Interest
The term "interest", as it is used in Economics, means a return on capital only. It does not refer to the total amount which a debtor may be paying to the creditor. But it refers only to that part of the payment which is for the use of capital only. The total amount which a creditor charges from a debtor by way of interest is really gross interest. It is composed of several other payments besides pure or net interest. The gross interest means the total amount which a debtor pays to a creditor, and the net interest means that part of the payment which is for the use of capital only.
Samuelson defines interest thus: "The market rate of interest is that percentage return per year which has to be paid on any safe loan of money, which has to be yielded by any safe bond or other type of security, and which has to be earned on the value of any capital asset (such as a machine, a hotel , building, a patent right) in any competitive market where there are no risks or where all risk factors have already been taken care of by special premium payments to protect against risk."
What people ordinarily call interest is called gross interest in Economics.
Gross interest is composed of the following elements: —
(i) Insurance against Risk. A creditor knows from his experience that some of his debtors are not going to repay. He is thus running a risk when he advances money: The loss which will arise from the non-payment of certain debts is distributed over the debtors who do not fail to make the payment. Thus, good debtors have to pay for the bad debtors. Every debtor is charged a certain percentage as an insurance against the risk of non-payment.
The risk may be personal, e.g., the debtor turns out to be dishonest and runs away with the money; or the risk may also be a business risk, i.e., the borrower is not able to run the business successfully for which he borrowed the money. The result in both the cases is the same, i.e., the creditor does not get the payment.
(ii) Return for Inconvenience. A lender has to suffer certain inconveniences for which he seeks compensation in the form of interest. When a person tends money, he loses command over it for a period. He is thus unable to make use of it for himself, if he wants to. Favorable opportunities of its employment may also slip by.
The inconvenience to the lender is mainly of two types:
(a) He may himself need money at some future time, and he may not get it back. In that case he may have to borrow and pay interest himself.
(b) He may get back the money when he cannot find for it some safe and lucrative investment so that his money lies idle and he loses interest. He must, therefore, compensate himself for such losses. Hence, he charges something extra over and above pure or net interest.
(iii) Wages of Management. The money-lenders have to do a great deal of work in the money-lending business. They have to keep accounts and they have frequently to visit their debtors reminding them about the loan. They have also to visit the courts in connection with litigation arising out of the money-lending business. It seems to be their whole-time job. If they had not been engaged in Ibis business, they would have earned something by taking up another job. In other words, by taking to money-lending, they have lost the chance of making money by doing something else. This loss also has to be borne by the debtors.
(iv) Pure or Net Interest. If from gross interest we deduct the above three items we are left with pure or net interest. This is interest proper. It is this amount which is regarded as the reward of the third agent of production, viz., capital.
The money invested in 'gilt-edged securities' like Government loans or treasury bonds runs very little risk of being lost. Hence, the interest paid on such investments does not include much of the other elements. It is the nearest to net interest.
This distinction between gross and net interest is very helpful. When we find widely different rates of interest being charged in various places and from different persons, we know that the" differences are in gross interest only. Net interest tends to be the same, provided there is perfect mobility of capital, just as it tends to be uniform everywhere when all payments for inconvenience and risks are deducted.