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Interest is a fee paid by a borrower of assets to the owner as a form of
compensation for the use of the assets. It is most commonly the price paid for
the use of borrowed money,1 or money earned by deposited funds.2
When money is borrowed, interest is typically paid to the lender as a percentage of the principal, the amount owed to the lender. The percentage of the principal that is paid as a fee over a certain period of time (typically one month or year) is called the interest rate. A bank deposit will earn interest because the bank is paying for the use of the deposited funds. Assets that are sometimes lent with interest include money, shares, consumer goods through hire purchase, major assets such as aircraft, and even entire factories in finance lease arrangements. The interest is calculated upon the value of the assets in the same manner as upon money.
Interest is compensation to the lender, for a) risk of principal loss, called credit risk; and b) forgoing other investments that could have been made with the loaned asset. These forgone investments are known as the opportunity cost. Instead of the lender using the assets directly, they are advanced to the borrower. The borrower then enjoys the benefit of using the assets ahead of the effort required to pay for them, while the lender enjoys the benefit of the fee paid by the borrower for the privilege. In economics, interest is considered the price of credit.
Interest is often compounded, which means that interest is earned on prior interest in addition to the principal. The total amount of debt grows exponentially, most notably when compounded at infinitesimally small intervals, and its mathematical study led to the discovery of the number e.3 However, in practice, interest is most often calculated on a daily, monthly, or yearly basis, and its impact is influenced greatly by its compounding rate.
According to historian Paul Johnson, the lending of "food money" was commonplace in Middle East civilizations as far back as 5000BC. They regarded interest as legitimate since acquired seeds and animals could "reproduce themselves"; whilst the ancient Jewish religious prohibitions against usury were a "different view".4
In the Roman Empire, interest rates were usually calculated on a monthly basis and set as multiples of 12, apparently for expedient calculation by the wealthy private individuals that did most of the moneylending.5
The First Council of Nicaea, in 325, forbade clergy from engaging in usury6 which was defined as lending on interest above 1 percent per month (12.7% APR). Later ecumenical councils applied this regulation to the laity.67 Catholic Church opposition to interest hardened in the era of scholastics, when even defending it was considered a heresy. St. Thomas Aquinas, the leading theologian of the Catholic Church, argued that the charging of interest is wrong because it amounts to "double charging", charging for both the thing and the use of the thing.
In the medieval economy, loans were entirely a consequence of necessity (bad harvests, fire in a workplace) and, under those conditions, it was considered morally reproachable to charge interest.citation needed It was also considered morally dubious, since no goods were produced through the lending of money, and thus it should not be compensated, unlike other activities with direct physical output such as blacksmithing or farming.8 For the same reason, interest has often been looked down upon in Islamic civilization, with most scholars agreeing that the Qur'an explicitly forbids charging interest.
Medieval jurists developed several financial instruments to encourage responsible lending and circumvent prohibitions on usury, such as the Contractum trinius. Download