The main focus of the Interest Theory is on the charged amount paid against borrowed money. Though money is the most familiar form of asset at the time of lending, yet during arrangements of fiscal lease, Interest Theory considers other asset forms like consumer goods through hire purchase, shares, factories, aircrafts and other primary assets as well. In each of these cases, the rate of interest is charged on the total asset values, just like it is calculated on money.

Historical Facts about the Theory of Interest:

The origin of the Theory of Interest can be traced back to as early as 1500 B.C., during the time of the Egyptian and Sumerian civilizations. Further reference of this economic concept also prevailed in the Abrahamic religious documents, in the form of counsel against excessive interest. So it is not that the Interest Theory was altogether a new concept; though the theory polished and updated itself with passing times.

As per the Theory of Interest, different types of interest exist in today’s global economic market, like:

Simple Interest: Simple Interest calculates the interest amounts either on the total principal amount only, or on the unpaid part of it.

Compound Interest: Compound Interest calculates interest on an existing interest amount. In this case, the principal amount changes with each time period, and the interest incurred during that period gets added to the principal amount.

Fixed and Floating Rates of Interest: While the interest rates remain constant in the case of Fixed Rate of Loans, the Floating Loan Rate is variable .

Cumulative Interest or Return: It presumes compounding of interest at each payment date. It generally compares 2 long-run loan opportunities.

Theoretical make-up of interest rates:

The Theory of Interest Rates takes into account the cost of money, so subject to alterations due to inflation. The minimum rate of interest primarily considers the actual interest rate along with inflation. It is this minimum interest rate or the price before alteration due to inflation, which is made available to the customers.

Market interest rates:

Market interest rate is the primary concern of the Interest Theory. The rate of interest in the global investment market is determined on the basis of the prevailing conditions of retail fiscal organizations like banks, bond market and financial market. Each type of debt considers the following factors before calculating its rate of interest:

Opportunity Cost: It includes all those areas where money cannot be invested, like offering loans to others, holding and spending cash amounts as well as financial investments in other fields.

Inflation: The lender, on the face of inflation, tends to postpone his consumption. He would like to recover money sufficient enough to pay for the increased cost of goods. The interest rate are increased in such a situation to make room for inflation.

Interest Rates and Credit Risk: They are closely associated with one another. In fact, it is extremely popular a concept in today’s commercial sector.

Find below various interest rate theories given by classical economists, Neo-Classical Economists, Keynes and others:

The general theory of employment interest and money

Loanable Funds Theory of Interest

Time Preference Theory of Interest

Mathematical Theory of Interest

Classical Theory of Interest

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