Interest: Meaning, Gross and Net Interest

Interest is the reward paid to capital — more precisely, to the lender or saver — for parting with the use of money or capital for a period of time. It can equally be understood as the "reward for waiting": the compensation a saver requires for postponing present consumption and making funds available for someone else (or for investment) instead.

In practice, the interest actually paid by a borrower to a lender — the gross interest — is rarely a payment for the pure use of capital alone. It typically bundles together several distinct elements:

• Net interest (or pure interest): the payment made purely for the SERVICE of capital itself — what would be paid even on a perfectly safe, perfectly convenient loan, with no risk and no trouble of management at all.
• Payment for risk: compensation to the lender for the possibility that the borrower may default and the loan may not be repaid.
• Payment for inconvenience: compensation for the trouble and cost of managing/administering the loan, and for the loss of liquidity the lender suffers by not having that money available for other uses while it is lent out.

Two classic explanations of what determines the RATE of interest are studied at this level:

• Classical (demand and supply of capital) theory: the rate of interest is determined where the demand for capital (mainly for investment) equals the supply of capital (mainly from savings) — the same demand-supply logic used for any other factor price. …