When you go to borrow money from a bank you will need to pay the bank back with two forms of payment:
- The principal.
Let’s use an easy example to illustrate these two concepts.
Principal is the amount of money you are borrowing. Imagine you need a loan for $1,000. The principal of the loan is equal to $1,000. But the bank providing you the loan wants to be compensated for providing this capital, and needs to account for the fact that you might not pay the funds back.
So what does the bank do? They charge interest.
Interest is the percent of the loan that you must pay the bank for the benefit of using their money. Loan payments can occur weekly, monthly, quarterly, or even bi-anually.
In order to understand why a bank considers interest important, think about how a bank operates and earns money.
A bank has customers who deposit money into accounts. This money, while sitting there, needs to remain liquid. In other words, the owner of that account needs to be able to access liquid money whenever they visit the ATM or go to make a withdrawal.
The bank knows this and pools its customer’s accounts so that it can loan this money out and earn some rate of return.
To make this rate of return, the bank loans money to other people – individuals, companies, organizations, and even other banks – with the expectation that this money will be repaid in full.
If banks were unable to make loans, they would have a far harder time making money. For this reason, loans with interest are important.
The second reason why interest is important is because some people that take out loans will not repay the value of the loan. This represents a risk to any lender. So a bank needs to pool its risk exposure.
Lastly, banks charge interest because of inflation. Imagine a bank gives you money and asks for that loan to be repaid in 30 years. If they leant you $1,000 today, what is that worth in three decades. It is hard to say. But the future value of that money needs to be paid and the person borrowing the capital performs that task.
For all of these reasons, banks charge interest. Interest is central to the business model of loans, helps banks reduce risk, and helps both the lender and the lendee price in inflation to the loan value.