Why Do Lenders Charge Interest on Loans?

If apple growers charged a zero price for apples, very few apples would be supplied. Similarly, if lenders, who are suppliers of credit, didn’t charge interest on loans, there would be very little credit supplied. Recall from your introductory economics course the important idea of opportunity cost, which is the value of what you have to give up to engage in an activity.

Just as the price of apples has to cover the opportunity cost of supplying apples, the interest rate has to cover the opportunity cost of supplying credit. Consider the following situation: You make a $1,000 loan to a friend who promises to pay back the money in one year.

There are three key facts you need to take into account when deciding how much interest to charge him:

(1) By the time your friend pays you back, prices are likely to have risen, so you will be able to buy fewer goods and services than you could have if you had spent the money rather than lending it;

(2) your friend might not pay you back; in other words, he might default on the loan; and

(3) during the period of the loan, your friend has use of your money, and you don’t.

If he uses the money to buy a computer, he gets the use of the computer for a year, while you wait for him to pay you back. In other words, lending your money involves the opportunity cost of not being able to spend it on goods and services today.

So, we can think of the interest you charge on the loan as being the result of:

● Compensation for inflation
● Compensation for default risk—the chance that the borrower will not pay back the loan
● Compensation for the opportunity cost of waiting to spend your money

Notice two things about this list. First, even if lenders are convinced that there will be no inflation during the period of the loan and even if they believe there is no chance the borrower will default, lenders will still charge interest to compensate them for waiting for their money to be paid back.

Second, these three factors vary from person to person and from loan to loan. For instance, during periods when lenders believe that inflation will be high, they will charge more interest.

Lenders will also charge more interest to borrowers who seem more likely to default. The reward lenders require for waiting to be repaid can also vary across time and across lenders.