Imagine for a moment that you are a merchant in ancient Greece or Phoenicia. You
make your living by sailing to distant ports with boatloads of olive oil and spices.
If all goes well, you will be paid for your cargo when you reach your destination,
but before you set sail you need money to outfit your ship. And you find it by
seeking out people who have extra money sitting idle. They agree to put up the money
for your voyage in exchange for a share of your profits when you return . . . if you
return. The people with the extra money are among the world’s first lenders, and you
are among the world’s first borrowers. You complain that they’re demanding too large
a share of the profits. They reply that your voyage is perilous, and they run a risk
of losing their entire investment. Lenders and borrowers have carried on this debate
ever since.
Today, people usually borrow from banks rather than wealthy individuals. But one
thing hasn’t changed: Lenders don’t let you have their money for nothing.
Lenders have no guarantee that they will get their money back. So why do they take
the risk?
Because lending presents an opportunity to make even more money.
For example, if a bank lends $50,000 to a borrower, it is not satisfied just to get
its $50,000 back. In order to make a profit, the bank charges interest on the loan.
Interest is the price borrowers pay for using someone else’s money. If a loan seems
risky, the lender will charge more interest to offset the risk. (If you take a
bigger chance, you want a bigger pay-off.)
But the opportunity to earn lots of interest won’t count for much if a borrower
fails to repay a loan. That’s why banks often refuse to make loans that seem too
risky. Before lending you money, they look at:
• how much and what types of credit you use, such as credit cards, auto loans, or
other consumer loans;
• whether or not you have a history of repaying your loans, and
• how promptly you pay your bills. Banks also use interest to attract savers. After
all, if you have extra money you don’t have to put it in the bank. You have lots of
other choices:
• You can bury it in the backyard or stuff it in a mattress. But if you do that, the
money will just sit there. It won’t increase in value, and it won’t earn interest.
• You can buy land or invest in real estate. But if the real estate market weakens,
buildings and land can take a long time to sell. And there’s always the risk that
real estate will drop in value.
• You can invest in the stock market. But like real estate, stocks can also drop in
value, and the share price might be low when you need to sell.
• You can buy gold or invest in collectibles such as baseball cards, but gold and
collectibles fluctuate in value. Who knows what the value will be when it’s time to
sell? (In 1980, gold sold for $800 an ounce. By 1983, the price had sunk below $400.)
Or you can put the money in a bank, where it will be safe and earn interest. Many
types of bank accounts also offer quick access to your money.
Interest is the price borrowers pay for using someone else’s money.
