What Is Interest?

Interest is the cost of borrowed money: the amount a borrower pays over and above the principal, expressed as a rate. In short, it can be thought of as the price of money over time — the compensation for getting today's money back at a later date. The return on instruments such as bonds, bills, repo and deposits is usually expressed as interest, and the rate is most often quoted as an annual percentage.

Principal and interest

A lending relationship has two basic quantities. The principal is the original amount lent or invested. Interest is the amount paid in exchange for the use of that principal. For example, if 100 units are lent for one year, the part paid at maturity on top of the principal is the interest. The period that determines when payment is due is called the term (maturity); interest is generally computed from the term and the rate. The figures here only illustrate the concept; they do not represent any current rate.

Simple interest and compound interest

Interest can accrue in two different ways.

• Simple interest is calculated only on the original principal. Interest earned does not itself earn further interest.
• Compound interest works by adding each period's interest to the principal, so that in the next period it too earns interest — the "interest on interest" effect.

Over long horizons the difference between the two grows, because compounding accumulates exponentially. How often compounding occurs (yearly, monthly or daily) also affects the outcome: the more frequently interest is added to the principal, the faster the balance grows under the same nominal rate. For how this cumulative effect appears in investment returns, see compounding.

Nominal interest, real interest and inflation

The quoted interest rate is usually the nominal rate — expressed without removing the effect of inflation. Yet the purchasing power of money changes over time because of inflation. The inflation-adjusted rate is called the real interest rate.

Structurally, as an approximation:

Real interest ≈ Nominal interest − Inflation

The precise calculation divides the nominal return by (1 + inflation). The key point is that even a positive nominal rate can produce a negative real interest rate if it falls below inflation; in that case purchasing power declines. For the same distinction applied to fund returns, see real return.

Where interest appears for a fund investor

A fund investor usually meets interest indirectly, through the assets in the portfolio rather than directly:

• Bonds and bills: debt instruments such as bonds and bills mean lending to the issuer; the coupon and return they pay are based on interest.
• Repo and reverse repo: in repo transactions a security is funded short-term under a repurchase commitment, and the price difference is interest in nature.
• Deposits: the return paid on money placed with a bank is also interest.
• Money market funds: money market funds are positioned mainly in short-term, interest-bearing instruments (deposits, repo, short-term debt instruments), and their return comes largely from interest. You can review these on the money market funds page.

So a fund's "interest income" does not reach the investor as a direct interest payment; it appears as the value and income of these instruments feeding through into the fund's price. Interest rates also move with market conditions and central-bank decisions; as a general rule, when rates rise the price of an existing fixed-rate bond in the market falls, and when rates fall it rises. This inverse relationship is one of the main reasons the value of funds holding interest-sensitive instruments fluctuates.

The interest-free alternative: participation-based instruments

For investors who wish to avoid interest-bearing instruments, interest-free (participation-based) alternatives exist. In this approach the return is grounded in sources such as rental income, trading profit or a share of ownership rather than interest.

• Sukuk (lease certificates) are issued against an underlying asset; their return is based on rent or income sharing.
• Participation funds build their portfolio from assets that comply with interest-free principles, and can be seen on the participation funds page.

This distinction is a matter of preference; which approach to choose is the investor's own decision. The aim here is only to define the two structures.

In short

Interest is the cost of money against time: the rate paid on top of the principal. It can accrue simply or compound, and be expressed in nominal or real terms; once inflation is removed, what remains is real interest. A fund investor mostly meets it indirectly through bonds, repo, deposits and money market funds, while for those who wish to avoid interest there are participation-based alternatives such as sukuk and participation funds.