What does Interest represent?
Interest represents only the consideration for the passage of time. Do you agree?
While interest is predominantly the consideration for time value of money, it also includes consideration for the credit risk associated with the principal amount outstanding during a particular period of time. It also includes consideration for other basic lending risks and costs as well as a profit margin. Contractual cash flows representing solely payment of principal and the interest (SPPI) on the principal amount outstanding are consistent with a basic lending arrangement. The two significant elements of interest are:
- Consideration for the time of value of money
- Credit risk associated with the principal and interest
In extreme economic circumstances, interest can be negative where the holder of a financial asset pays for the deposit of its money. Where the contractual term gives rise to an exposure to risks or volatility in the contractual cash flows, which is considered to be unrelated to the basic lending arrangement, such contract does not give rise to cash flows that are solely payments of principal and interest.