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Most agreements for borrowing and lending include a provision for interest, which means the borrower is obligated to repay an amount greater than the initial sum borrowed.

Interest as a Common Feature of Debt Contracts

The interest rate is the price of bringing purchasing power forward in time through borrowing. It is formally defined as the additional amount a borrower must repay per period, expressed as a proportion of the original loan amount.

Interest Rate Definition

An additional motivation for a lender to provide a loan is the prospect of earning interest. Interest is the amount a borrower pays over and above the original loan amount (the principal). This promise of receiving more in the future than what was lent now serves as a significant incentive for the lender to part with their assets temporarily.

Interest as an Incentive for Lenders

A person borrows $1,000 from a financial institution. The terms of the agreement require them to pay back the full amount borrowed plus an additional $100 over the course of one year. What is the total amount of money this person is obligated to repay?

Analyze the financial arrangement described in the case study below. Calculate the total amount the borrower will repay and explain what the difference between the total repayment and the initial amount borrowed represents.

Analyzing a Simple Loan Agreement

A small business takes out a loan for $10,000. According to the loan agreement, the business must repay a total of $10,750 to the lender after one year. Break down the total repayment amount into its two fundamental components and state the value of each.

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