What is interest? Account for variation in rates of interest on loans of different kinds.

Interest is the price paid by borrower to the lender for the sue of loan able funds during a certain period. It is normally expressed as a percentage on the funds loaned or borrowed. In the word of Esthan, “Interest is the payment for parting with the advantage of liquid control of money balances.”

According to Betch, “Interest is the price paid for use of money or credit.”

There is an element of monopolistic competition in the money market in as much as different borrowers are charged different rates of interest. It may be noted however, the pure interest tends to be the same if calculated over the same period of time in the same money market. The actual differences that prevail are difference in the degrees of risk involved and inconveniences suffered by the lenders.

Differences in Pure Interest:

If pure interest is calculated over the same period of time in the same money market, it will tend to be the same. It can however differ in different markets on account of the following reasons.

1) Difference in the period of loan: If a borrower takes a long term loan from lender then he will charge a higher rate of interest than what he charges for short period loan. It is because the lender has to part with his money for a longer period, so he must demand a higher rate of interest.

Secondly in long term loan, the risk of the loss of funds due to dishonesty or incapability of the borrower is more than on a short term loan.

Thirdly businessmen demand money for fairly long period in order to invest that fund in fixed equipments, like building, machinery etc, so they are ready to pay higher rate of interest.

Fourthly, the lender hesitates to lockup their money for longer period, keeping in view the various risks involved. Due to all those factors stated above the supply of loan able funds runs short of demand for loan able funds, and the rate of interest goes up. On the other hand for short period, the risk for loss of capital is less than on long period. The supply is generally in excess of demand for this fund. So the rate of interest is usually low.

Short term and long term rates of interest generally move in the very same direction. If short term rate of interest is high, the long term rate of interest is also generally low.

2) Difference due to Distance: Pure interest can also differ due to difference in the distance of money market. It is the desire of every money lender to reduce the risk of non-payment of money. So they will prefer to invest their amounts near at home at a lower rate of interest than at a higher rate of interest at long distance.

3) Difference in Size of Loan: Pure interest can also differ due to the difference in the amount of loan demanded. The higher the amount demanded for loan, the higher the rate of interest and vice versa.

Difference in Gross Interest Rates:

Differences in rates of gross interest are mentioned as below.

1) Difference in the Social Status: If a borrower enjoys good reputation in the society for his honesty and prompt payment of loan or he can offer good security, then he can get loan at a comparatively low rate of interest.

2) Difference in Productivity: If the entrepreneur is satisfied that the investment of borrowed capital in a particular enterprise is profitable, then he will be ready to pay higher rate of interest. But he expects the reward to below, then naturally he will not be willing to pay higher rate of interest. Thus variations in gross interest can also arise due to the difference in productivity. In the words of Richard: “The interest rate charged on individual business is usually determined in the personal negotiation between Bank and borrowers. It reflects such attributes as the borrower’s size and general credit standing, the access to alternative credit source, the size and maturity of loan the character of the borrowers business, the value to the bank of his deposit amount and of other business relationship and the nature of security if any to be pledged.