4.1.1 Debt and interest – some basics
When someone acquires a debt, the money they have to repay to the lender consists of three elements.
First, there’s the amount originally borrowed – this is normally referred to as the principal sum, or sometimes the capital sum. Let’s say £10,000 is borrowed for five years to buy a car, how will this be repaid? There are two usual ways in which this principal sum can be repaid: either in one amount at the end of the term of the loan (in this case, five years), or in stages over the life of the loan. The former is often referred to as an ‘interest-only loan’ and the latter a ‘repayment loan’. If the principal sum is to be paid off in full at the end of the loan period, the borrower will need to have the money available through building up other savings to pay off the loan. An example of this type of loan is an endowment mortgage, which used to be a common way of buying a home – an interest-only loan is combined with saving through an endowment insurance policy that hopefully builds up enough lump sum to pay off the loan at the end of its term.
Second, there’s the important additional cost of having debt: the interest that has to be paid on it. In effect, interest is an additional charge on the repayment of debt. It is normally expressed as a percentage per year – for example 7% per annum, more commonly abbreviated to 7% p.a. The charging or paying of interest is generally rejected by sharia law, as it used to be by some Christians in earlier centuries. In modern economies the concept of interest comes about because lenders require recompense for three factors: for the access to the money they have given up; for the risk associated with not getting their money back; and to cover the expected inflation rate over the coming year.
Third, there may be charges associated with taking out, having or repaying debt. These will be explored in more detail later.