Interest: The Price of Money

I’m Andy Temte and welcome to the Saturday Morning Muse! Start your weekend with musings that are designed to improve financial literacy around the world. Today is August 2, 2025.

Over the past few months, we've explored the origins of global trade, traced the evolution of money, and seen how trust became the bedrock of banking. Last time, we discovered how banknotes evolved as promises—IOUs that revolutionized commerce by making money portable and scalable.

But here's the thing about promises: they're not free.

When I lend you my car for the weekend, I can't use it. When a bank lends you money to buy a home, that capital sits locked up for up to thirty years. This brings us to one of the most fundamental—and historically contentious—concepts in economics: interest.

What Is Interest?

At its core, interest is the price of time. More specifically, it's compensation for allowing someone else to use your money today instead of you using it yourself. Think of it this way: if I give you $100 today, you get the benefit of spending that $100 right now. But I lose the opportunity to spend or invest that cash. Interest is what you pay me for that privilege.

But there's a deeper layer here that connects directly to our June discussion about inflation. Remember how we explored how the purchasing power of money erodes over time? That same $100 I lend you today will buy less stuff when you pay me back next year if inflation is running at, let’s say, 3 percent. So interest isn't just about opportunity cost—it's about preserving purchasing power.

This is what economists call the "time value of money." A dollar today is worth more than a dollar tomorrow because of three realities: inflation erodes purchasing power, money can be invested to earn a real return, and there's always risk that a dollar invested today might not recouped in full, or at all.

The Interest Rate Equation

Here's where it gets practical. For any lender—whether it's your neighbor, a community bank, or JPMorgan Chase—the interest rate they charge must cover three things:

First, expected inflation. If I expect prices to rise 3 percent over the next year, I need at least 3 percent interest just to break even in purchasing power terms. This is the inflation premium.

Second, a real return. I'm giving up the use of my money, so I deserve compensation beyond just maintaining purchasing power. Maybe I want 2 percent real return for my trouble. This is the real risk-free rate.

Third, risk compensation. There's always a chance you won't pay me back. The riskier the loan, the higher this premium needs to be. Maybe I need 4% to compensate for that risk. This is the risk premium.

Add them up: 3% inflation + 2% real return + 4% risk premium = 9% interest rate. Those are the basics of how interest rates are determined.

How Interest is Calculated

Let's start with the most basic method of how interest is computed: simple interest. This represents the most fundamental way to calculate interest, though in future Muses we'll explore the more powerful concept of compounding in detail. The formula for simple interest is straightforward:

Interest = Principal × Rate × Time

If I lend you $1,000 at 5% simple interest for two years, here's the math: Interest = $1,000 × 0.05 × 2 = $100

You'd pay me back $1,100 total—the original $1,000 plus $100 in interest.

Simple interest is linear. It doesn't compound. Each year, you pay interest only on the original principal amount. If you borrowed that $1,000 for ten years at 5% simple interest, you'd pay $50 in interest each year, totaling $500 over the decade.

I learned about interest the hard way—as most of us do. My first bank loan at nineteen was for lighting equipment for my rock band. Since the collateral was professional lighting gear for a group of young adults with musical dreams, the risk premium was quite high!

But here's what struck me: the banker wasn't being greedy. They were running a business that had to account for the cost of money, the risk of default, and the erosion of purchasing power. When I finally understood this, I stopped seeing interest as punishment and started seeing it as the price of accessing opportunity today. We’re going to talk more in the future about the benefits and risks of loans and debt.

Why This Matters Today

Understanding interest isn't academic—it's survival in the modern economy. Every mortgage payment, every credit card statement, every business loan reflects these same principles we've outlined. When you see a 6% mortgage rate, you're seeing the market's collective judgment about inflation expectations, risk levels, and the real time value of money.

More importantly, understanding interest helps you make better decisions. Should you pay off your 3% mortgage early or invest that money in the stock market? Should you take out a business loan to expand operations? Should you finance that car or pay cash? You can't answer these questions intelligently without understanding what interest really represents.

Interest rates are the price signals that coordinate our entire economic system. They guide resources from savers to borrowers, from those with excess capital to those with productive opportunities. When interest rates are low, borrowing is cheap, encouraging businesses to expand and consumers to make major purchases. When rates are high, savers earn attractive returns on deposits and bonds, while borrowers face expensive financing costs that discourage spending and encourage saving instead.

This is why central banks pay such close attention to interest rates—they're not just numbers on a screen, they're the steering wheel of the economy.

The Human Element

But here's what makes this story truly fascinating: for most of human history, charging interest was considered morally wrong. Ancient civilizations, major religions, and entire legal systems prohibited or severely restricted interest. Yet economic reality kept pushing back. Commerce demanded credit, growth required investment, and trade needed financing.

Next week, we'll explore this tension—how civilizations from ancient Babylon to medieval Europe grappled with the moral implications of charging for the use of money. We'll see how clever merchants found workarounds, how religious scholars debated exceptions, and how practical necessity ultimately shaped our modern understanding of interest.

For now, the key insight is this: interest isn't arbitrary. It's not just banks being greedy. It's the market's way of pricing time, risk, and opportunity. Understanding this makes you a more informed borrower, a better saver, and a wiser participant in our complex financial world.

Until next week…

Grace. Dignity. Compassion.