(1) Payment for Risk:
The man who lends the money is known as creditor. Every creditor knows that some of borrowers will never repay the money. So there is risk of non-payment. This risk of non-payment is of two types such as personal risk and business risks. In case of personal risks the person concerned does not pay the money.
In case of business risks he does not pay because his business fails. In both the cases the lender losses. In order to cover up this loss he charges a little more to compensate this loss. Every borrower is charged with certain percentage to cover up the risk of non-payment.
(2) Reward for Management:
Reward for management means the reward for services of management of loan. When loan is given accounts are to be maintained. The repayments are to be recorded. The date of installment and repayments are to be reminded by letters or by personal visits. In case of default legal steps are taken. All these mean expenditure. The lender knows it and therefore charges a rate of interest higher than the actual interest.
(3) Payment for Inconvenience:
Payment for inconvenience means the inconvenience to the lender on account of lending. Sometimes after he lends the money he needs it. He borrows for it and pays rate of interest. Sometimes the money is not paid in time. So he charges higher rate of interest to cover up the inconveniences.
If we deduct all the elements from the gross interest we arrive at the net interest.
The gross interest can be summarised as:
Gross Interest = Net Interest + Reward for Risks + Reward for inconvenience + Reward for management.
Net Interest = Gross Interest – (Reward for Risk + Reward for inconvenience + Reward for management).