Principle 6: Markets work well with competition, the rule of law, information, incentives, and property rights.
Principle 8: Fiscal and monetary policies influence people’s decisions.
Objectives:
Use supply and demand analysis and the role of the Federal Reserve Board to explain interest rate determination
List the reasons why interest rates for different types of loans differ
Use the three C’s of credit to evaluate loan applications
Use a credit calculator to investigate the marginal opportunity costs of choosing different payment options
Use benefit/cost analysis to decide whether to make a purchase on credit or to pay cash
An interest rate is the price that borrowers pay for a loan and the price that lenders receive for a loan. Like all other prices, interest rates are determined by competition among lenders against lenders to make the loan and competition among borrowers against borrowers to obtain the loan. While that statement is a gross oversimplification, the overall statement is true. There are, however, some major differences between product and labor markets and credit markets. The Federal Reserve Board is the central bank of the United States. One of its major functions is to promote price stability and full employment. The Fed manipulates interest rates to pursue those goals. Since an interest rate is the price of credit, it is a bit misleading to claim that the credit market is a competitive market. You will learn much more about the Federal Reserve in later summaries.
Different types of credit, different interest rates
Many people complain about high credit card interest rates. They are, indeed, higher than the rate on a 30-year mortgage loan. There is, however, a reason for that. In the first quarter of 2020, 9.1% of credit card holders were over 90 days delinquent. That means that credit card lenders were likely to lose 9.1% of the money they loaned credit card holders. That is billions of dollars! In the same period, total credit card debt was $890 billion so credit card companies were likely to lose $8.1 billion. To cover these losses, credit card companies seek a higher rate than other lenders. The way to avoid that higher rate is to repay the entire debt each month, in which case borrowers usually pay no interest at all.
There are many different credit instruments. Different types of loans include payday loans, credit card loans, automobile loans, mortgage loans, home equity loans, college loans, personal loans, and others. Just as there are different markets for different types of workers, there are different markets for different types of loans. Each type of loan has different interest rates and different conditions for obtaining the loans. In general, interest rates vary depending upon the credit score of the borrower, the length of the loan (the longer the payback period the higher the interest rate to account for uncertainty), and whether the loan is backed by collateral (guaranteed, by something that can be used to repay the debt such as a car or a house) in case the borrower defaults on the loan.
The three C’s
Lenders consider three things when evaluating a loan.
Capacity: does the applicant have sufficient ability to repay the loan? Potential lenders will investigate job security, income, wealth, and other variables
Collateral: Will the loan be secured?
Character: Will the applicant be responsible and repay the loan? Potential lenders consider a borrower’s credit score as one of the criteria used to evaluate a loan. A credit score is determined by many factors and heavily influences decisions by potential lenders, employers, renters, and others. The range of FICO scores is 300 – 850.
Should you use credit?
Credit is much like a healing drug. You should use if for its proper purpose, but you should not abuse it. Below are some situations that most credit wise people consider proper uses of credit.
Purchase of an asset that you know will have a high return such as a student loan which will strengthen your human capital (training or education)
Purchase of big-ticket items such as cars and houses where most people would not be able to pay cash as the down payment and monthly payments are within your budget
Although an emergency savings fund may be a better alternative, credit is often a necessary method of payment during emergencies such as health crises, unexpected and unavoidable expenses, college textbooks until your scholarship money comes in.
any credit card purchase if you know that you will pay it off when the bill comes in, it fits your budget, and the opportunity cost is one you are willing to pay
In general, you should ask yourself the following questions before using credit.
Is the item something that is likely to have a high payoff either as an investment or other long-term benefit?
Do you have the capacity to make the payments on time?
Is the opportunity cost of the credit use something that you are willing to “pay?”
Here are some situations that are probably not a good use of credit
Purchase of something you really, really want but you just can’t afford
Purchase of a trip that your richer friends are taking
Purchase of TV stations that your friends all have
Any credit purchase that you are not going to be able to repay
Bottom line:
Interest is the price of credit and is determined by the interaction of buyers and sellers with heavy influence from the Federal Reserve Board
Different types of loans have different interest rates
Lenders consider three things when evaluating loan applications, the three C’s – Capacity, Collateral, and Character
In deciding whether to use credit for a purchase, it makes sense to consider whether
the item will have a significant reward
the borrower will be able to repay the loan
the benefit of using credit outweighs the opportunity cost
Making higher monthly payments and getting a lower interest rate will reduce the amount of time it takes to repay the loan and the total interest paid on the loan.
1. Who determines interest rates?
a. Borrowers
b. Lenders
c. The Federal Reserve Board
d. All of the above
2. Which of the following loans is likely to have the highest interest rate?
a. Personal loan, low credit score
b. 15-year mortgage loan, good credit score
c. 30-year mortgage loan, good credit score
d. Insufficient information
3. Which of the following is NOT one of the three C’s of credit?
a. Confidence
b. Collateral
c. Character
d. Capacity
4. Which of the following might not be a bad credit decision?
a. You have a secure job and a solid budget. You are tired of riding your bike four miles to work and home. You would like to buy a car.
b. You are a carpenter and your table saw just died. You will have to buy a new one.
c. You saw a necklace that you just HAVE to have. It’s more than you can afford but you can just put it on your credit card.
d. You are moving into an apartment and will have to come up with first and last month’s rent and a cleaning deposit in a few days. You start work at your new job in one week and will be in a strong financial position.
5. Which of the following statements is/are true?
a. Higher interest rates shorten the time it takes to repay the loan and the total interest paid on the loan.
b. Higher interest rates shorten the time it takes to repay the loan but lengthens the total interest paid on the loan.
c. Higher monthly payments lengthen the time it takes and the total interest paid on the loan
WHO GETS THE LOAN?
THREE C’s: Summary
1. Capacity: your present and future ability to meet your payments. Is your income substantial? Have you had a substantial income stream for a long time? Have you had the same job for a number of years?
2. Capital: your savings and other assets, which can be used as collateral for your loan compared to other debt that you must repay. Are you currently in a strong enough financial position to be able to make payments on the loan under consideration?
3. Character: your history of how you have paid your bills or debts in the past. The word credit comes from the Latin word meaning “to believe.” The question is, “Do your previous credit record and other activities present sufficient evidence that you take your debts seriously and that you repay them on time. Should the lender believe you?
You have $800,000 to lend. To whom will you lend? The maximum score for each category is 5.
Ginny and Derek
Ginny and Derek are college graduates. They have both been working for two years. Their combined income is $97,000 per year. They both have two credit cards which they pay off at the end of each month. They have two car payments which they have always paid on time. The balance of Ginny’s car is $15,000 and the balance on Derek’s is $12,000. They are currently renting and they have never missed a rent payment. They want to borrow $250,000. They have $20,000 saved for a down payment.
Jerome
Jerome is a 24 year old single male. He is employed and has had five different jobs in the last 6 years. He has no savings. He declared bankruptcy two years ago. He lives with his parents. He would like to borrow $400,000 for a small home. He has no money for a down payment.
Maria and Pablo
Maria and Pablo have a combined income of $75,000. They live in a home that is worth $320,000. They still owe $75,000 on their home. They have one car payment with a balance of $4500. They have two credit cards and make their payments on time. They had a dispute with a contractor and did not pay his bill for over a year while they were working out the arguments on both sides. The case went to small claims court and they won, but it hurt their credit rating. They plan to sell their house and buy a four bedroom worth $450,000. They will have to borrow $200,000.
Marissa
Marissa has a good job as a legal assistant. She has had the job for five years and earns $35,000 per year. She has had an apartment and has paid her rent on time. She has no other credit history. She has no car payments and no credit cards. She pays cash for everything. She has a savings account with a balance of $18,000 and a retirement fund. She would like to borrow $325,000.
Ricky:
Ricky is an electrician. He earns $50,000 per year. He has been employed by the same company for six years, first as an apprentice, and then as a licensed electrician. His FICO score is 650. He has missed paying a few bills but there is no pattern of delinquency. He has three credit cards and has made his payments on time. His current balance is $650. He lives with his parents and pays them a small amount each month. He has $15,000 in saving. He wants to borrow $300,000 for a home.
Stephanie
Stephanie is a high school graduate. She has no job and no credit history. She lives with her parents and pays no rent. She wants to borrow $25,000 for a new car so that she can look for work.
Capacity | Capital | Character | Total Score | Desired Loan | |
Jerome | $400,000 | ||||
Ginny and Derek | $250,000 | ||||
Ricky | $300,000 | ||||
Stephanie | $ 25,000 | ||||
Marissa | $325,000 | ||||
Maria and Pablo | $200,000 |
Sean’s credit cards
Sean got himself into a little bit of trouble. He got one of those “free” credit cards and started racking up the dollars. He now owes $15,000 on the card with an 18% interest rate. He is investigating his options. He knows he will have to work more hours at the pizza place, which he hates (customers can sometimes be rude!) and cut back on the simple things that he usually buys ---takeout food (no pizza, he has had enough of that), new shoes, fancy haircuts, lots of apps on his phone, some jewelry, etc. He didn’t realize the opportunity cost of borrowing when he was charging all this stuff. He is hoping to pay more, and he may be able to transfer the debt to another card which charges less interest. Go to https://www.calcxml.com/do/pay-off-loan?skn=# and see how the amount of his payments and the interest rate affect him. Complete the table below.
Alternative | Interest rate (%) | Monthly payment | Years to repay | Interest paid | Interest as percent of loan |
1 | 18 | 250 | 12.9 | $23,664 | 158% |
2 | 14 | 250 | |||
3 | 12 | 250 | |||
4 | 14 | 300 | |||
5 | 14 | 350 | |||
6 | 14 | 400 |
It is obvious that no credit card is free. Use the concept of opportunity cost to explain to Sean the cost of his loan.
In row 1, Sean is making a relatively small payment and paying a high interest rate. What does that do to the amount of interest he pays on the loan. And the amount of time it takes to repay the loan?
In rows 2 and 3 he is able to secure a lower interest rate. What impact does that have on the time to repay and the amount of interest he will pay?
In rows 4, 5, and 6, Sean is reducing the time it takes to repay the loan and the total interest that he pays by making larger monthly payments. Explain how these decisions illustrate marginal benefit/marginal opportunity cost analysis.
Write a brief letter to Sean explaining what you have learned from this exercise and what actions he should consider in using his credit card.