Gross InterestExplained & Defined

Written By:
Lisa Borga

What Is Gross Interest?

Gross interest is the amount of interest a borrower needs to pay a lender for the use of the money they are borrowing.

This is the interest paid before taxes, fees, or any other charges are deducted.

It includes the opportunity cost, payment against the risk covered, and management service charges.

There are a number of different components that make up gross interest, and they are discussed below.

Pure Interest

Pure interest is the payment the borrower gives to the lender solely for the use of the borrowed money.

It is also called net interest.

Net interest does not include other money paid for management service charges, payment for inconveniences or risk covered.

Payment for Risk Taken by the Lender

If a person or financial institution lends money to another person or a business, there is always a risk that the principal and interest owed will not be paid.

The lender also faces the risk that business conditions will change.

Because of these risks, the lender charges the borrower a certain amount of money beyond the interest they are charging for the use of the money being borrowed.

Management Service Charges

When a person or business borrows money, the lender needs to manage the loan.

This involves all the legal work as well as the record-keeping and bills or reminders sent to the borrower.

In order to cover these costs, the lender includes service charges in the gross interest the borrower must pay.

Payment for Inconveniences

After a lender provides capital to a borrower, the funds are no longer available for the lender to use.

Therefore, the lender loses any money that could have been earned through investing the money.

Additionally, the value of the money that was borrowed will decrease over time. Because of these inconveniences, the lender charges the borrower extra money as part of gross interest.

The Calculation of Gross Interest

Here is the formula for computing gross interest.

Gross Interest = Pure Interest + Payment for the Risk Taken by the Lender + Management Service Charges + Payment for Inconveniences

Gross Interest Example

Suppose Mr. Jones borrows $500,000 from Mr. Smith. Mr. Smith will receive an interest payment one year after he lends the $500,000 to Mr. Jones.

This interest payment can be divided into four categories as follows.

• Pure interest solely for the use of the $500,000 borrowed, which is $25,000
• Payment of $5,000 for the risk the borrower is taking of not receiving payment for the money borrowed
• A management service charge of $500
• Payment for any inconveniences of $250

The gross interest can be computed by adding all of these payments together.

The gross interest would be $30,750.

Gross Interest Vs. Net Interest

There are a number of differences between these two types of interest.

Here are some of them.

• Gross interest considers management service charges, payment for inconveniences, and payment for risk covered in addition to the payment for the use of the money borrowed. In contrast, net interest only consists of the money paid for the use of the capital and does not consider the payment for the risk taken and other factors.
• Gross interest is a more inclusive payment. It consists of more than just the payment for the use of the money borrowed. It consists of net interest and more.

Conclusion

Pure interest is the interest that a borrower must pay a lender for the use of the lender’s money.

But, gross interest involves more than this. Gross interest includes pure interest along with other charges.

It takes into account the risk of the borrower not paying the amount owed and the inconveniences the lender faces in making the loan, as well as the lender’s cost of managing the loan.

So, when someone is thinking about borrowing money, it is important to consider all of the charges that will be a part of the gross interest they will be paying.

This way, they will understand the full costs of borrowing the money.