Definition of Gross Interest:
“The interest earned on a deposit or security before the deduction of tax, is known as gross interest“.
Example of Gross Interest:
A bondholder receives interest payments on the bond periodically. The gross interest is the amount of the bondholder receives from the issuer, and not what he or she keeps after paying taxes.
Elements of Gross Interest:
Gross interest is composed of some or all of the following elements:
(i) Net Interest. When the word “interest” is used in economics, it refers to net interest. Net interest is the payment for the services of loan-able funds.
(ii) Insurance against Risk. When a lender advances money to a borrower, he undertakes risks. For example, a borrower may turn out to be dishonest and refuses to pay back the interest and the principal sum loaned or he may invest the fund in a risky enterprise and thus lose all his money in the bargain. In all such cases as it is the lender who is to suffer, so he demands an additional payment as insurance against the possible risks of default of payment.
(iii) Payment for Inconvenience. When a sum of money is loaned to a person, the lender is put to two types of inconveniences. Firstly, if he himself is in need of money at anytime he will not be able to realizes it from the borrower as that is loaned for a specific period. Then he will have to borrow from other people. Secondly, the borrower may repay the money at a time when it is not possible to find out a safe and profitable investment. The money may remain idle for some time. The lender will go without interest for the period when it is not loaned. Realizing all these inconveniences beforehand, the lender usually charges an additional sum over and above the pure interest.
(iv) Remuneration for Services. The lender has to keep a record of the total amount loaned and repaid by the borrowers. He has to issue reminders or notices for the payments of debts. In case the loan is not paid at the due date, then he may have to file a suit against the borrower in the court. For all these inconveniences and services, the lender must be compensated some extra amount over and above the pure rate of interest.
Definition of Net or Pure Interest:
If from the gross interest, we deduct the payments made for:
(a) Insurance against risks.
(c) For services of the lender.
We are left with net or pure interest. Net interest is, thus, the payment for loan able funds only.