Lenders have been despised for most of history. They make borrowers pay for loans, while just sitting around doing nothing. No wonder people have been vilified for charging interest. No wonder that for centuries, clerics pointed to biblical passages damning interest.1 Even philosophers like Aristotle weighed in against the practice, calling the "breeding of money from money" unnatural.
After scorning lenders for millennia, today we recognize their service as a fundamental building block of civilization. Credit is one of the critical mechanisms we have for allocating resources. Without it, our market-based economy would grind to a halt. Even the simplest financial transaction, like saving some of your paycheck each month to buy a car, would be impossible. And corporations, most of which survive from day to day by borrowing to finance their activities, would not be able to function. Credit is so basic that we can find records of people lending grain and metal from 5,000 years ago. Credit probably existed before common measures of value, and it predates coinage by 2,000 years.2
Despite its early existence and its central role in economic transactions, credit was hard to come by until the Protestant Reformation. By the 16th century views had changed, and interest payments were tolerated if not encouraged, so long as the rate charged was thought to be reasonable. Some historians even point to this shift as a key to the development of capitalism and its institutions. Protestant European countries did develop faster than Catholic ones, at least at first.3 Since then, credit has exploded, facilitating extraordinary increases in general economic well-being. Yet even so, most people still take a dim view of the fact that lenders charge interest. Why?
The main reason for the enduring unpopularity of interest comes from the failure to appreciate the fact that lending has an opportunity cost. Think of it from the point of view of the lender. People who offer credit don't need to make loans. They have alternatives, and extending a loan means giving them up. While lenders can eventually recoup the sum they lend, neither the time that the loan was outstanding nor the opportunities missed during that time can be gotten back. So interest isn't really "the breeding of money from money,'' as Aristotle put it; it's more like a rental fee that borrowers must pay lenders to compensate them for lost opportunities.
It's no surprise that in today's world, interest rates are of enormous importance to virtually everyone—individuals, businesses, and governments. They link the present to the future, allowing us to compare payments made on different dates. Interest rates also tell us the future reward for lending today, as well as the cost of borrowing now and repaying later. To make sound financial decisions, we must learn how to calculate and compare different rates on various financial instruments. In this chapter, we'll explore interest rates using the concepts of future value and present value and then apply those concepts to the valuation of bonds. Finally, we'll look at the relationship between inflation and interest rates.
1Even today, the payment of interest is legally prohibited in countries like Iran, which follow the Islamic code of Shariah. In these countries, only payments for risk taking are allowed; debt contracts of the kind we make are banned.
2See Sydney Homer, and Richard Sylla, A History of Interest Rates, 3rd ed. (New Brunswick, NJ: Rutgers University Press, 1996).
3Max Weber makes this argument in his classic work The Protestant Ethic and the Spirit of Capitalism, first published in 1905.