"It is the compensation which the borrower pays to the lender, for the profit which he has an opportunity of making by the use of the money."
-- Adam Smith
What is interest
In the Netherlands, interest is called rent. That is exactly what interest is. Someone lends you capital and expects rent on the use of that capital. The longer the period they lend you that capital, the more demand there is for it, or the riskier it is to lend it to you, the higher the rent. The same factors that effect any other property that is lent.
What is compound interest?
This is interest where the capital is lent out for more than one period, and the interest is not paid in the first period but collated to be paid at a later period.
This means in the second period, there is the interest to pay on the original capital still lent, but also the interest on the interest also lent out.
Can compound interest be made illegal?
"Interest is not something that can be abolished or legislated away, because it is part of human nature. "
- Re-invest your money each year so it doesn't compound.
(no-one could get a loan of more than a year then)
- Increase the term of the loan, so the compound amount would be implicit
(this means all the interest is paid in one lump sum rather than instalments- rates would increase to compensate for risk).
- Move your money overseas.
(few would get loans at all)
Even if you could outlaw it, savers would take their money out of banks and invest in shares/property/gold with implicit compounding.
- People would find it harder to get loans and mortgages.
- It would hurt the elderly and retired who rely on investment income
- Administrating it would cost a lot, meaning possibly less nurses and doctors.
"in an economical point of view, the loan itself can never be considered responsible for previous necessities, which it has not created, and which it relieves to a certain extent."
"In some countries the interest of money has been prohibited by law. But as something can everywhere be made by the use of money, something ought everywhere to be paid for the use of it. This regulation, instead of preventing, has been found from experience to increase the evil of usury. The debtor being obliged to pay, not only for the use of the money, but for the risk which his creditor runs by accepting a compensation for that use, he is obliged, if one may say so, to insure his creditor from the penalties of usury."
-- Adam Smith
Put simply if you want to borrow someone's property long term like a car, the person/company who owns that car will expect some compensation. They want compensation for not having the use of the car, and the risk of not getting it back. Possibly also for the revenue they could have otherwise generated with the car. That's how car rental companies work, and the more of a risk you are, or the longer you want the car the more it costs. When borrowing money, the same principle applies. Charging interest on money is no worse than charging rent on any other item, especially since money is interchangeable for other items.
"The depression of interest is proportioned to the abundance of capitals."
"If the legal rate of interest in Great Britain, for example, was fixed so high as eight or ten per cent. the greater part of the money which was to be lent, would be lent to prodigals and projectors, who alone would be willing to give this high interest. Sober people, who will give for the use of money no more than a part of what they are likely to make by the use of it, would not venture into the competition."
-- Adam Smith