What is interest?
Hundreds of years ago, making money on loans was the equivalent of profiting from someone else’s misfortune. When people borrowed money from each other, they did so from a place of necessity, not desire. Society would frown upon anyone who profited from the act of lending money. How could anyone benefit from lending money, you ask? The answer: interest.
Interest is the fee you pay when you borrow someone else’s money. Everyone has borrowed money at some point in their life. Ever taken out a car loan or student loan? Ever made a credit card purchase, or even borrowed 5 dirhams from a middle-school friend to buy a plate of fries? If you have, then you’ve borrowed.
Lenders are inconvenienced in two situations. First, when the amounts borrowed are significant. Second, when the time needed to repay the loan is long. The cost of that inconvenience is what we call interest. Interest rate is the percentage of the amount lent you must pay to a lender each year.
If you borrow 1,000 dhs from me today, and agree to pay me 5% interest per year, then next year you’d have to pay me back 1,050 dhs (1,000 plus 5%).
Interest is a two-way street
As with all things in life, interest is a two-way street (or a one-way street if you drive a motorcycle in the Middle East). You could pay it for the privilege of borrowing money from someone or from a bank, but you could also earn it when you lend someone your money.
The poor and the middle class work for money. The rich have money work for them. Idle money is stupid money.
There are generally two things you can do with money you earn: nothing, or something. Doing nothing with your money means let it accumulate in your bank account, paycheck after paycheck. Doing something with your money means put it to work and have it earn interest for you. There are literally hundreds of ways you can do this, but because you’re busy, I’ll do you a favor and eventually distill them down to two or three options.
For now, it’s important to remember working long & hard for your money only to watch it sit in your bank account doing nothing is the equivalent of buying a Ferrari and parking it in your garage 5 days a week. Idle money is stupid money. This is one of the recurring themes you’ll see in your journey to financial independence.
As an investor, your aim is to find the best opportunities to become a lender. Lend your money to the safest and most reliable borrowers. And do so while we you earn a decent amount of interest in the process.
How are interest rates determined?
The long answer will require a whole post on its own. The short answer, however, is interest rates generally depend on the reliability of the borrower.
Do you have that friend that always asks you to lend them some cash because they forgot their wallet at home? If that friend is reliable, you wouldn’t think twice before you lend them the cash; You know you’ll get it back without embarrassingly chasing for it. On the other hand, if that friend is forgetful and constantly travels, it may be months before you see that money again.
Think of interest rates as a direct representation of the emotions you get when asked for money; If you feel uneasy lending to that person, interest rates should be higher to compensate for your emotional distress (dramatic much?). If you feel comfortable lending to that person, interest rates should be lower since you won’t suffer as much.
The concept of “risk vs. reward” may be familiar to you. You will quickly see that if you take on more risk, your reward must be higher to compensate you accordingly.
If there’s one thing to remember, it should be that your goal as an investor is to maximize the interest you make on your savings, and minimize the interest you pay on your loans. That’s it.