The Costs of Lending
Loans involve the advance of funds by a person or institution to another person or institution to be paid back in the future. Loans almost always involve the payment of interest, unless the loan is from a family member or through some special arrangement, for instance with an interest free loan from the government or one’s employer.
It does cost money to loan money though, due to things like opportunity costs, risk, and inflation. Most loans are loaned by for profit enterprises, banks and other financial institutions, who look to recover these costs in addition to earning a profit on these deals.
There are always opportunities with money, and when one chooses one opportunity over another, in this case lending the money out, one must forego these other opportunities. So for instance a bank may loan you money, instead of investing it in bonds or using it for some other purpose that would benefit the bank. So as a baseline, they would need to earn more from the loan than with this other use, and this sort of thing is called opportunity cost.
Related to this is the rate of inflation that is expected during the period of the loan, and while opportunity cost does cover this, because even with inflation, what matters is what else the money could be used for, this does serve to discount the stream of future payments.
So if the interest charged were less than the inflation rate, the bank would lose money on it in terms of the value of the money received back. So we may expect the interest rate charged to be greater than the rate of inflation to account for this, and this is why rates on loans are interest sensitive.
On top of this, we need to add in default risk, and when someone does not pay back a loan, the bank will need to write off a portion of it. This is calculated by the total of the outstanding balance less what it may receive by liquidating the loan, selling it to a collection agency for instance, or selling off the collateral put up for the loan.
When banks have to liquidate collateral, they typically receive less than the amount owed, especially due to the fact that these assets are typically sold below their market value, for expediency. Banks are not in the business of holding these assets and they generally want to dispose of them quickly to get them off their books.
So this risk is priced in, and this is why different borrowers will often receive different rates, based upon how risky the lender perceives them to be. This is called risk based pricing. So the better your situation, your credit and your debt ratios for instance, the better the interest rate you will often receive, especially if the loan is unsecured.
The Decision To Borrow
The two main categories of loans are personal loans and business loans. With a personal loan, the purpose of the loan is of a personal nature, used toward personal consumption, or held in reserve for future consumption. So we could say that the ultimate purpose here is one of personal utility, which we could call pleasure in some sense.
The purpose of business loans is to borrow money to make a profit on, so the terms of the loan must correspond with this goal, to allow for this to happen, or at least expect to make a profit with enough reasonable certainty that one is willing to take out the loan at the terms involved.
The utility gained in taking personal loans is a sort of profit as well, in fact it is profit just as much as a business loan would be, other than the fact that this profit isn’t defined monetarily in most cases, although sometimes it is. An example would be a personal loan to be used for investment, or other purpose that may add to one’s wealth, in which case one must approach this from a purely economic perspective.
Typically though, the benefit isn’t going to be so easy to calculate, although we always want to use the ultimate cost of the loan to decide the potential benefits of it. When we use money to purchase something, we have a sense of whether or not the purchase is valuable enough to make, weighing both the cost in money terms, and the benefit, which is usually non monetary.
This should always be measured in terms of opportunity cost, the value of spending it on one thing versus another, where the alternatives include both spending it now and at a future date. Holding money in savings can be seen as a benefit as well, both real and psychological, as it’s comforting to have a certain amount of money in reserve to deal with unforeseen expenses.
As we look to do this, we need to account for the true costs if we must borrow to purchase whatever we’re looking to buy, and this is something many people don’t account for. We do tend to discount money in the future quite a bit, and some of this is natural, as it’s generally preferable to have something now versus later, so we’ll tend to pay more now for it than having to save up for it and buy it later.
The part that people tend to miss is that you also need to account for the increased cost later as well, and for instance, if you buy something and put it on a credit card, and will likely spend twice the price for it when you calculate the interest payments, the value of having it now may not be such a great deal.
There are plenty of good reasons to borrow though, and this isn’t just about being frugal with interest, but we do need to be aware of the costs and benefits involved to some degree if we’re going to make wiser decisions about whether it’s good to borrow or not in a given instance.
Loan Types and Terms
There are two major forms of borrowing money, an installment loan and a revolving loan. Installment loans involve the borrowing of a specific amount, with a fixed payment schedule which amortizes or pays down the loan eventually over a period of time. A revolving loan allows the borrower to borrow up to a certain amount, the credit limit, and make periodic payments on it.
Installment loans may be either a fixed or variable rate. A fixed rate locks in an agreed upon rate for the term of the loan, where a variable rate loan can move up and down with the institution’s prime rate, which fluctuates with the market.
Fixed loans offer more certainty over the term, while variable rates generally offer lower rates but are subject to more risk. Depending on the spread between them, which is how much lower the variable rate is, where one expects rates to go during the term, and one’s risk appetite are determining factors in deciding which to go with.
While risk tolerance does factor into the decision, this tends to be overrated by borrowers, but if one cannot easily manage fluctuations in rate, this can matter quite a bit, as borrowers need to make sure they can meet their obligations if rates increase.
Revolving products are almost always have variable rates. If one doesn’t need the money right away, a revolving product is the better choice, as you pay interest from the moment the funds are advanced so you would rarely want to be holding these borrowed funds for future use.
Credit cards are always revolving, as our lines of credit. Mortgages are always installment loans, although one can get a home equity line of credit that is secured by home ownership and is revolving.
Both installment loans and revolving credit lines can be secured. Secured loans put a lien on property, so that if the borrower defaults, the lender can liquidate the pledged assets, like for instance a home foreclosure or repossessing a car.
Often, but not always, the assets pledged are the ones that are purchased by the loan, but some loans are secured with other assets, which may include investments. One may also purchase investments with borrowed money, where the investment may or may not secure the loan, but these loans are more risky and must be only taken when the expected return isn’t just higher than the rate, as it needs to be high enough to account for the risk.
If not, you can actually lose money on the investments and end up paying interest for the privilege. However, losses aren’t realized until the investment is sold, so this strategy can make sense if the proper investments are made and they are going to be held for long enough that the risk of selling at a loss becomes minimized.
One may also realize tax savings from the investment, and together with holding the investments for retirement, this strategy can be a good one in some cases anyway.
The main principles of borrowing are making sure that borrowing is the best way to acquire what you need, ensuring that the cost of borrowing is worth it as opposed to saving for it or not buying at all, and seeking the most suitable borrowing product with the lowest interest rate.
Borrowing can be a great strategy to get what you want or need without having to wait, but it always must be done with proper deliberation.