The Anatomy of a Loan
March 20, 2016
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Loans: The Good, the Bad, and the Ugly

They say that liquidity is the grease that lubricates our economy. People, businesses, and governments need access to cash for operations and financing. Sometimes we come up short, and need to borrow. We might be low on money, or it might be impractical to convert some of our wealth back into cash to meet an obligation. Without credit, it would be very difficult to conduct business or finance a lifestyle in America. Loans are vital lifelines that have allowed farmers to produce society’s crops for millennia and have given countless businesses their start. However, loans are presented as simple products, but have deeper implications than are typically advertised or understood.

What are we told a loan is? 

A loan is something that is borrowed, especially a sum of money that is expected to be paid back with interest.

What else is a loan?

A loan is money made available now, but with implications. Most think of a loan as access to cash. In our society, credit (a borrowed sum) is treated nearly identically to money. Lent money in your bank account appears in the same way that earned or given money does. Taco Bell can’t tell whether you bought your Beefy Five Layer Burrito with borrowed money or savings (unless you purchase with a credit card, where a loan is made on the spot). Sellers also do not care a great deal whether you purchase with borrowings or savings – once they get their money, the rest is between you and the lender.

The above might be true, that a loan does give you access to cash, and that you need to pay it back with interest, but that is only a partial explanation of what you have agreed to. To go a step further, a loan is a trade with somebody else. The counterparty (entity on the other side of your loan) figures out an amount of compensation that they deem fair in return for giving you money now. This compensation (quoted as an interest rate) takes into account a number of factors, which you’ll find in many finance textbooks. The main risk that a creditor faces is default risk. If circumstances come along that render you unable to pay your debt back, the creditor is put out on that loan, or not made whole. To account for this possibility, they add a premium to a base interest rate, usually a margin or spread above the prime rate. The prime rate is what banks offer their most creditworthy customers, usually corporate clients with strong business relationships. Other factors come into play, like interest rate risk, prepayment risk, or systemic risk, and all of these go into your quoted rate. Once you’ve been quoted, you can take the cash or leave it at that point.

…that feeling when the money gets wired to your account

When you sign on the dotted line of your loan, the bank is making a trade with you. They give you money now, and you return them more money at a later date. How much more you pay back is derived from your interest rate and fees. Some loans require more than 20% annual interest. Here’s a chart with common loan types and interest rates charged to creditworthy borrowers (3/2016, assuming good credit).

Product Annual Rate Typical Term
Average Auto Loan 2.60% 4 years
30 Year Single Family Mortgage 3.75% 30 years
Average Student Loan 4% – 7% 10 Years
Average Credit Card Interest Rate 15% Variable
Average Payday Loan 400% 1-4 weeks

When you make this trade with a lender, you implicitly believe that you are making out with at least a fair deal. You either want cash badly enough, or can justify the interest rate with some other compensatory factor. Some of the things that would make your loan a better trade are rising inflation, changes to interest rates (direction depends on loan type), improved earnings, and a number of other factors.

Inflation – as the rate of inflation increases, money becomes less valuable in terms of the goods and services it affords. If you take out a loan for $10,000 and the rate of inflation rapidly increases, you are now paying back the principle on that loan with dollars that are less valuable than before (paying back less in real terms). This is especially advantageous when the loaned money is used to purchase an appreciable asset such as a home, stock, or commodity, which all tend to hold up well in the face of inflation.

Interest Rates – If you take out a fixed rate loan, then rising interest rates make your rate look like a wiser choice, while falling rates can usually be refinanced with a bank or institution. Rising rates are bad if you have a variable rate, and falling rates help you as a borrower.

Earnings prospects – as you earn more, your ability to service debt improves. If the loan you took out is put towards something constructive like a successful business, or a higher returning security, then you can collect the spread as profit, only paying the bank back for the loan. This is how financial leverage works when used successfully.

While a loan can represent a trade with a counterparty (money now in exchange for money + premium later), it can also be viewed as a trade with yourself. When you take on debt, you are usually pledging your future earnings for immediate proceeds today. That leaves your future self on the hook for eventual payments. At this point, it becomes apparent that debt can create value, or destroy it. This can be illustrated with two examples.

Example 1: Creating value through debt

John is a plumber. He currently works for someone else making $60,000 per year. However, John can go out on his own and make $100,000 per year as an independent business owner. In order to do so, he needs $30,000 in cash to pay for startup costs, like tools and a vehicle. It would take John three years to save up that much money, based on his other obligations. Instead of waiting, he taps the capital markets for a $30,000 loan. John no longer has to wait to start his business, and can very quickly begin enjoying higher earnings. Over that three year period, John makes an extra $120,000 (($100k – $60k) * 3 years), making his $30,000 loan well worth it. Even if his interest rate was an outrageous 20% APR, the payback would only be $40,000 – still a good trade. Debt gave John leverage and a head start.

Example 2: Destroying value through debt

Amy makes $70,000 per year as a financial analyst. She is getting by, but doesn’t have much left over at the end of each month in disposable income. However, Amy is itching to buy a new car and has her eyes set on a brand new Mercedes. She would need to take out a $30,000 loan to buy the car, which she does. As she drives that car off of the lot, Amy has lost about 25% of the automobile’s value. Yet, her loan payment is still $30,000 plus interest and the car will continue to depreciate. Now Amy is on the hook each month for a car payment, which is money that could have otherwise gone towards bills, a vacation, Christmas gifts, you name it. Amy has destroyed value and taken freedom away from her future self by purchasing something with debt that declined in value. To be clear, purchasing anything that declines in value without offsetting benefit is not a wise choice, but using debt to do so aggravates the effect further, since you are paying interest on top of the borrowed principle. We now live in a society where many students go into massive debt for a college degree that does not lead to a large earnings increase beyond what’s already available to them in the market without a degree. Choices like these can destroy value and become a drag on personal finances for a generation or longer.

Thinking about debt as a deal with your future self is one way to enhance financial decision making. Would you like to leave future self you with more financial freedom or less? This is a question that we often fail to ask, but are forced to acknowledge as a consequence of financing. The two examples above illustrate that loans can be used well or poorly. Debt can help you grow and achieve new heights if it is utilized to fund a sound investment. On the flip side, loans can be squandered and destroy a person’s future very easily. The instrument is not necessarily good or bad – it’s all about the application.

Milton Freidman examined the way that people consume across their lifetimes and arrived at the Permanent Income Hypothesis – that we borrow early in our lives to live beyond current means, paying back those debts when our earnings increase over time. Loans do allow for an expansion of lifestyle, but only to the point at which these increases are paid for at another point in time. Some borrowing is near required for many people who grow up without a support system or quantity of savings – however many of us simply perceive that we cannot survive within our means at a point in time when it might merely be uncomfortable to do so.

A loan is also a promise – with both finances and reputation at stake. Many loans are secured with collateral, meaning that a lender can lay claim to an asset of yours if you fail to pay your debts back. A common example is a home loan. Banks can usually foreclose on you and take back the home you are paying down if you fail to meet your obligations. Auto loans are subject to repossessions as well in the face of default. Creditors can also lay claim to other assets of yours than what the loan is purposed for if stipulated in the contract. For instance, a lender may be able to take ownership of your car and liquidate it for cash if you default, even for a personal loan.

That promise that you are held accountable for also factors into your credit standing. Missed payments or a default can decimate someone’s credit score, and the effects can be felt for years. I admire those with a debt free lifestyle, but for the many who benefit from the responsible use of borrowing, a credit score makes the undertaking simpler and easier to bear. See http://www.financialsamurai.com/how-a-bad-credit-score-ruined-a-persons-career/ for an account of bad credit and its effects.

The Parts of a Loan

Loans are marketed as simple solutions to your financial needs, however, the amount to pay back rarely matches the intuitive mental math we run in our heads based on the advertised inputs. At the end of the day, your loan is made up of three different parts (excluding down payment). These include your principle, interest, and fees/other.

Principle – This is the portion of a loan that you were sniffing around for in the first place. You wanted a $50,000 business loan, and that $50,000 is the principle you must pay back. Wall Street has a number ways to work this repayment out – whether they be staggered, lump sum, or steady repayments over time. However, for simple consumer loans, your principle is usually amortized with fixed installments over the term of your obligation.

Interest – Interest is the cost of capital as they say in finance – literally what the lender charges you for the privilege of receiving their money. Interest is quoted as a rate (usually per annum), which can be converted to dollars. One thing that you must know is the compounding period of your loan’s interest. Loans range from continuously compounding to annual or even longer periods. Other loans do not exhibit compound interest, most mortgages in fact. However, these loans do exhibit compounding behavior as a result of changing principle payments over time (see http://thefinancebuff.com/is-home-mortgage-simple-interest-or-compound-interest.html or an amortization schedule). Interest adds up, even in simple interest arrangements. For instance, many people are shocked to discover that they pay out approximately the same amount of money in interest on a thirty year mortgage as they do for the home itself. See the book The Banker’s Secret for a thorough explanation of the topic.

Fees/Other – A number of other line items make it into your loan as well. Depending on what type of debt you are taking on, there might be origination fees, sales taxes, property taxes, inactivity fees (credit cards), prepayment fees, insurance, disbursement fees (student loans), repayment fee (after forbearance period), or a plethora of others. People should be aware that many fees are rolled up into the loan amount to which interest applies. This is a fundamental area in which quick mental math can go awry when calculating loan balances and payments. There are so many fees, which can be very product specific, that I cannot go into each type. However, there are many great resources online explaining the types of fees that you are likely to encounter for different types of loans. Some are predatory and purposeless – these should be noted and appealed for removal if you do not receive an adequate explanation.

What Happens to Your Loan?

You might take out a mortgage to buy a $200,000 house from your local bank. It seems intuitive that Small Town Savings Bank will keep tabs on that debt for the next 30 years, right? As made highly public in the coverage following the financial crisis of 2008, these loans tend not to stick around for very long on your local bank’s books. Sure, they will keep some, but most of those loans are sold off shortly after they are underwritten. While this video analyzes the larger implications of our most recent financial crisis, it also gives a great description of the quick sale of individual loans to larger investors.

https://www.youtube.com/watch?v=bx_LWm6_6tA

Why would a bank do this? It all goes back to risk. Say your $200,000 mortgage is worth $400,000 when you factor in fees and interest. If you walk away from that loan half way through its term, then the bank stands to lose about $200,000. That’s a pretty large chunk of change. However, They might be willing to sell it to an investor who can better absorb such a large risk, such as a bank or hedge fund. Say Small Town Savings sells the mortgage off for $300,000 – that gives them a healthy and fairly instant profit, leaving enough meat on the bone for the investor to work with. These more savvy entities (usually a securities firm like a Wall Street investment bank) will create a pooled product that in theory reduces financial risks like individual defaults. These asset backed securities may contain hundreds or thousands of loans, and are usually put together with a common profile (the loans come from a certain region, or the credit profiles of the borrowers are similar. From here, the securities are divided into tranches which promise cash flows to investors, who can weigh the risk of each tranche against the potential profit available to them.

Some Advice About Borrowing

1) The point of bringing these later stages f your loan up is to reinforce the idea that your local bank is simply a sales office when it comes to most loans. They are incentivized to get you a loan (the larger the better), and sell it off for a locked in profit before the ink is dry. The relationship you hold with your bank is about generating future sales (loans) for you, but they are not the custodian of your loans for long. Therefore, don’t be bashful in negotiating fees, working your interest down, and thinking twice about borrowing up to the limit the banks will allow. More recently these institutions have implemented corporate controls to curb reckless lending, but within these guidelines, a bank will still try to get you to borrow as much as they can allow. It’s how they make their money.

2) Another tip related to debt is making your payments early and beyond the required amount. You can save tens of thousands of dollars on mortgage interest by simply paying your monthly bill early by 2-4 weeks. This is because most amortized loans charge interest off of remaining principle. When you pay beyond required monthly amounts, that extra money is going straight to paying down principle, thus mitigating interest further on down the line in your loan term. If you look at an amortization schedule, it’s surprising to see how much of your first payments go solely to interest – you are paying next to nothing in principle in this early phase. Interest is calculated off of current present value of the loan, so larger balances lead to much higher interest payments as a share of the whole amount due in those early months.

3) There are two ways to evaluate loans that you owe money on – both are responsible, but will lead to separate approaches. The mathematical interpretation of loan pay down looks at expected interest rates and returns on potential investments. It makes logical sense to put as much of your financial energy towards retiring obligations with the highest interest rate, since these loans present the greatest potential savings when paid off early. You might also be mathematically inclined to behave differently towards your debt in the context of other returns on your capital that are available. For instance, if you took out a personal loan for 10% interest, it might make better sense to not pay down the debt if you have found an opportunity that guarantees you a 14% annual return. Instead, put your money toward the 14% yield, since foregoing interest expenses and earning yield on investment are two sides of the same coin.

In a different light, one could view their finances behaviorally, looking to pay down certain debts in spite of higher yielding market opportunities. This course of action prioritizes financial freedom and distaste for recourse above simple comparisons of yield out in the market. People who aggressively pay down debt are noted to engage in more financially responsible behavior down the line, and end up becoming more motivated to improve their personal finances. Either approach is a step in the right direction, and depends on the way you like to think.

4) For personal and auto loans, DO NOT negotiate on monthly payments. A hallmark of the financially irresponsible is the mode of thought that focuses on payments rather than total cost. Among those who do not consider the future, it’s common practice to spend up to your means of earning, perhaps beyond. If you make $2,000 per month, and you currently have $1,600 in bills, then that in theory leaves you with $400 to spend. Auto dealers are especially keen to prey on stupidity. They will ask customers how much they are looking to spend per month (some will answer $400). However, focusing on a single variable, the monthly payment, leaves multiple back doors to play with, in which clients take on an overpriced quote with excessive interest and fees. It’s a simple head fake – “think about payments while we adjust the length of the loan, and it’s terms/interest/fees.

Two loans cost about $450 a month. The first is for $25,000 and a five year term. The second is for $30,000 over six years, and also with a 3% rate. At a glance, both offer the same monthly payment – yet, the terms of these loans are very different. The six year is a great payoff and takes place over a longer time. What’s worse is that borrowers are never told that option a exists for better terms, assuming the inputs are inflexible. They give away the monthly payment information and the term/interest are played with to give the lender a big profit. With the advent of portable smartphone calculators, failing to examine and negotiate an auto loan is unacceptable.

5) Recognize that a loan is essentially borrowing money from your future self, as much as it is borrowing from somebody else. Maintaining conservative assumptions about future income, and having a road map of lifestyle preferences to begin with are critical, as this is a choice that balances the present and the future. Don’t unknowingly subject yourself to the years of living down a financial mistake that so many endure. Living within one’s means is a simple code to understand, but interest rates, loan calculations and income projections add some rigor to the thought process about what defines one’s means, and what they will be at a future date.

6) Failing to pay down your debt has major reputational consequences, not just financial ones. For those who are on the bubble when considering loan affordability, consider the lasting impact of a botched credit score on future financial options, namely applying for additional loans and credit cards. Debt can be used tactically to grow your wealth, but throws many aspects of our lives into question when misused. Some job interviews, apartment rentals, and insurance programs take credit score into account as a correlate of trustworthiness and responsibility. NOTE: for those who have suffered a financial setback relating to a credit score, fintech companies are beginning to build credit models that do not emphasize credit score, so much as other predictors or creditworthiness like income, college major, and age. It is worth checking out companies such as SoFi and Earnest for their list of service offerings and lending requirements.

7) Credit is a polarizing tool that favors those who need it least and evades those who need it the most. Capitalism, despite it’s many great attributes does penalize those with a record of prior mistakes, making additional chances incrementally harder to attain. There are ways to fix credit and repair finances, but they are very difficult processes when compared to simply maintaining solid books without setback in the first place. My best advice would be to remain ahead of the curve and avoid at all costs endangering yourself by entering a realm where you need money desperately. This requires a good deal of conservatism, as bad things happen to good people, and the universe does not show much sympathy towards the our plans and schedules.

8) Consolidate loans at low rates when possible. Many companies offer consolidation services which can help you refinance large portions of personal debt at low rates. This is particularly helpful for those who carry high interest rate student loans and are looking for a way to arrange terms that are less pressing and can allow a person to escape the quicksand of debt overhang.

There are volumes written on borrowing and debt. The math can get esoteric, the philosophy can get muddy, but for simpletons like you and I, a few common sense ideas can help to relieve us from a large majority of the trappings out there. There are reasons why entire societies prohibit loans and usery, but the truth is that shortfalls exist everywhere and ways of moving past these challenges exist. It’s up to us to think intelligently, weigh risks against reward, and know our financial escape plans in order to live independently and avoid reliance on a fair and transparent system that may or may not exist.

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