Analysis of Gross Interest:
Definition of Gross Interest:
"The interest earned on a
deposit or security before the deduction of tax".
Example of Gross Interest:
A bondholder receives
interest payments on the bond periodically. The gross
interest is the amount the bondholder receives from
the issuer, and not what he/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
instance, 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/Pure Interest:
If from the gross
interest, we deduct the payments made for: (a) Insurance
against risks, (b) Inconvenience and (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.
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