Q.Explain the concepts of Gross interest and Net interest and their components.
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Start your 14-day free trial to unlock the full solution →Net (pure) interest is the payment made only for the use of capital, with no other element. Gross interest is the total payment the lender receives and equals net interest plus reward for risk, reward for inconvenience of illiquidity, and payment for the trouble/cost of managing the loan. Gross interest = Net interest + Reward for risk + Reward for inconvenience + Cost of management.
Net interest
Net interest (also called pure interest) is the payment made purely for the use of capital and nothing else. It is the price of capital alone, free from risk, management cost or any other charge. It is normally low and is the interest on an absolutely safe loan.
Gross interest
Gross interest is the total amount actually paid by the borrower to the lender. Besides the pure price of capital it includes several other charges that the lender must be compensated for. Hence gross interest is always greater than net interest.
Components of gross interest
Gross interest is made up of the following parts:
1. Net (pure) interest: the reward only for the use of capital.
2. Reward for risk: lending involves two kinds of risk —
- personal (or bad-debt) risk — the borrower may fail to repay;
- business (trade) risk — the business in which money is invested may fail. The lender is compensated for bearing these risks; the greater the risk, the higher this reward.
3. Reward for inconvenience (illiquidity): by lending, the lender parts with his money for a period and loses liquidity; he must be paid for this inconvenience of not having his money readily available.
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