Financial Glossary
Interest
Interest is the cost of borrowing money, expressed as a periodic rate applied to the outstanding principal balance. For borrowers, interest is an expense; for lenders, it is income. Interest can be simple (calculated only on principal) or compound (calculated on principal plus previously accrued interest). Loan agreements specify whether rates are fixed (unchanged over the loan term) or variable (tied to a benchmark such as the Secured Overnight Financing Rate plus a spread). In accounting, interest expense on business debt is generally tax-deductible, reducing the after-tax cost of borrowing below the stated nominal rate.
Problem & Application
A campground operator borrows $500,000 at a 7.5% annual rate on a 10-year term loan to finance new electrical hookups. Annual interest expense in year one is approximately $37,500 (applying the rate to the outstanding balance; it declines each year as the principal amortizes). If the operator is in the 25% combined federal and state tax bracket, the after-tax cost of that interest is $37,500 multiplied by (1 minus 0.25) = approximately $28,125 -- the actual economic cost after the tax shield. Comparing this to the expected incremental revenue from the new sites ($90,000 per year at full occupancy) makes the economics clear. When interest rates rise, operators with variable-rate debt should evaluate whether refinancing to a fixed rate or purchasing an interest rate cap is worth the cost to stabilize cash flow projections.
In Short
Interest is a key factor in financial management, and companies need to monitor rates and borrowing terms to minimize costs and improve profitability.