Interest: The Price of Money

Money has a price.

Let’s say you won the gold medal for some prestigious competition, and your older brother offers you a cash reward. He asks you if you want to receive Php100,000 now, or Php100,000 next year. Many of you would choose to receive the Php100,000 now. This is because, first of all, you can spend the money now. Once you receive the Php100,000 now, you can use it immediately to settle debt, to buy necessities, or to shop for clothes and other things. For others, the Php100,000 can immediately be invested in the business or in a portfolio, and can thus earn profit. Still, other people may argue that if the older brother and you quarrel at some point in the future, he might change his mind and not give the money. Others with knowledge in economics will argue that money is subject to inflation, which means that money loses value over time.

Whatever your reason is, it is important to acknowledge at this point that money has time value. This means that money now is more valuable than the same amount at some future time. However, there is no agreement to how much more valuable money now is compared to the same future amount.

If instead of offering Php100,000 now or Php100,000 next year, your brother feels very generous and offers you Php200,000 next year, many of you might consider getting the amount in the future. However, if he only offers you Php100,001 next year instead of Php200,000, you might opt getting the Php100,000 now. The question can thus be phrased like this: How much is Php100,000 today worth to you one year now? This difference is called interest, which represents the price of money.

For instance, if you deposit this Php100,000 in a savings account in the Philippines, the best you can earn would be Php101,207, assuming no withdrawals are made and 1.5% gross interest compounded monthly. This amount also includes the 20% withholding tax that the government imposes on passive income.

When you borrow money from creditors, these people or institutions forego the use of their money now in order to help you. However, these people also charge interest, which represents the price you pay for borrowing their money. The concept of interest is consistent with the principle of the time value of money. Moreover, interest payments also compensate the lender on the risk from lending his or her cash. However, there are many different kinds of interest. These will be discussed in the next articles.