What is the purpose of charging interest on a loan?

• A. To compensate the lender for lending money.
• B. To punish the borrower.
• C. To increase the loan amount beyond the principal.
• D. To reduce the repayment amount.

Answer: (A)

Interest is the price charged for borrowing money. It exists because the lender is giving up the opportunity to use that money elsewhere, the money can lose value over time due to inflation, and there is some risk the borrower might not repay. Charging interest covers the cost and risk of lending as well as the time value of money. That’s why the purpose isn’t to punish the borrower or to secretly boost the loan amount beyond what was agreed, and it certainly isn’t to reduce what you pay back—the interest makes the total repayment higher than the original loan.