Part I · Chapter 1 · Ledger · lesson 4

Interest, from both sides of the table

10 min

Someone offers you 1,000 now, or 1,050 in a year. The 50 is not a bonus and it is not a reward for patience. It is a price, and what it is buying is a year.

Every interest rate in existence is that same price, quoted from one of two seats at the same table. Borrowers pay it. Lenders collect it. The number does not change when you swap seats — only the sign in front of it does.

Interest is rent on money.

Someone who lends gives up the use of an amount for a stretch of time and is paid for the inconvenience. Someone who borrows gets the use of that amount now and pays for the privilege. It is the same transaction described from two chairs, and there is no version of it where one side is doing the other a favour.

Which means every question about a rate has two answers, and they are the same answer. "Is 9% expensive?" and "Is 9% generous?" are one question.

What the rate is actually paying for

A rate is never one thing. Pull any quoted rate apart and you find at least three components stacked on top of each other.

The wait. Even with no risk at all and no inflation, money now is worth more than money later, because now you can do something with it. This part is small and it is never zero.

The risk of not being repaid. The lender is not comparing this loan against certainty. They are comparing it against a book of similar loans, some of which will not come back. Everyone who does repay is covering the ones who do not.

The expected loss of purchasing power. If prices are expected to rise 4% a year, a lender who charges 4% has been paid nothing. This one gets its own lesson shortly.

Predict

A lender quotes 4% to one borrower and 19% to another, for the same amount over the same term. What is the fifteen point difference mostly paying for?

Inflation, which affects the second loan moreThe chance the loan is not repaidThe lender's costs of doing the paperworkThe lender charging what the second borrower will tolerate

Both sides of the table, at once

Here is the thing people miss. Most adults are on both sides of the table simultaneously, and often at very different prices.

Holding 4,000 in an account paying 2% while carrying 4,000 on a card charging 22% is not a neutral position. It is renting money out at 2 and renting the same amount in at 22. The two do not cancel. They compound in opposite directions, and one of them is ten times louder than the other.

That does not automatically mean the debt should be cleared. It means the gap between the two rates is a real, ongoing cost, and if you are paying it you should be paying it for a reason.

What would you do

There is 6,000 in an account paying 2% a year. There is also 6,000 outstanding on a card charging 22% a year, with a minimum payment that covers a little more than the interest. Income is steady but the industry has been laying people off.

Optimising for: Get through a plausible three-month gap in income without borrowing again at a worse rate.
You cannot know: Whether the income actually stops, and for how long
Whether the card would still be available to draw on after it is cleared
Whether the rate on the card is fixed or can be moved by the lender
What borrowing would cost in three months' time, if it is needed

Clear the whole card todayClear half and hold halfHold the cash and pay the minimum

Something people say

“Interest is what lenders charge because they can.”

Why it spreads: Some of it demonstrably is. Rates offered to people with no alternative are visibly higher than the risk alone would justify, and anyone who has seen that up close has good reason to generalise from it.
The part that is true: Pricing power is real, and where a borrower has nowhere else to go the rate does climb above what the risk would price.

Take away every scrap of pricing power and the rate does not go to zero. A lender with perfect competition, no default risk and no inflation would still charge something, because they are giving up the use of the money for the term of the loan and that has a price to them.

The useful move is not to decide whether interest is fair. It is to split a quoted rate into the part that is the wait, the part that is the risk, and the part that is somebody having a good day at your expense — and to notice that only the third part is negotiable.

Worth remembering

Interest is rent on money: the same number is a cost to the borrower and income to the lender.
A quoted rate is at least three things stacked together — the wait, the risk of not being repaid, and expected inflation.
Most of the gap between a low rate and a high rate offered to two borrowers is the price of default risk.
Holding savings at a low rate while carrying debt at a high rate costs the gap between them, every year, whether or not anyone notices.
Two people can reach opposite conclusions from identical numbers by optimising for different criteria, and usually neither has said which.