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Floating the Principal

The Merciful, NON-inexorable Loan
 
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I. Background information

Most organizations that lend money do so to earn money. For a particular loan, the money currently borrowed is called the "principal", and the fee, charged at regular intervals for as long as any principal is still borrowed, is called "interest". Since the principal shrinks toward zero as a loan is repaid, the interest is usually computed as a percentage of the current principal. Most people regard that to be a fair concept: It means that the larger the principal, the larger the fee; the more a loan has been repaid, the smaller the current fee.

Lenders have various problems associated with their business. Here are four:

(A) They'd like to choose a high percentage rate when computing interest, maximizing their profits two different ways. First is the obvious size of the fee, but the second is more subtle. Large fees make it more difficult for a borrower to repay the principal quickly, which means the loan has a long lifespan, with the lender collecting those high fees for the duration. High interes rates, of course, repel prospective borrowers, especially if lenders compete with each other. Between competition and the fact that borrowing is often more a luxury than a necessity, lenders charging high interest rates will have fewer customers, and possibly less overall total income, than if they chose lower rates. Finding a competitive and profitable balance is every business' problem.

(B) A worse problem is the fact that not all customers are equally reliable. What good does it do a lender to charge a low rate, if the fee doesn't get paid? The traditional solution is to try to assess the reliability of each prospective customer, and to encourage reliability by associating interest rates with the lender's risk in making the loan. The greater the risk of the borrower failing to make a payment, the higher the fee.

(C) It is almost a cliche` that it is easier to borrow a million dollars than a thousand dollars, yet there is a good reason for it: Paperwork. Just about the same paperwork is associated with either size of loan, so why shouldn't a lender choose to make a single loan of a million dollars, instead of a thousand loans of a thousand dollars each? Processing paperwork costs money; a lender can either reduce its expenses by focussing on big loans, or it can charge a higher interest rate for smaller loans, to cover the cost of paperwork in reasonably straightforward fashion.

(D) When the borrower has repaid the principal, and perhaps no longer needs a loan, the lender's business is at risk. It must continually seek new customers, and go through the assessment process all over again, with each one. Note that the smaller the loan, the more often this aspect of the business recurs, so again there is a reason for lenders to prefer large loans over small, and to associate small loans with a higher interest rate.

In conclusion of this Background Information, please think about the simple fact that lenders need the interest on each loan to be regularly paid for as long as possible, much more than they need to have the loaned-out principal repaid. That fact is at the heart of this document.

II. A modest proposal

(1) Let the prospective loan, regardless of size, be associated with a flat up-front Paperwork Fee (two possible amounts). Lenders would compete here; the fee might be pretty small if an automated system existed to handle most of the paperwork. No real profit motive should be associated with computing this fee, because a high fee will repel customers, and steady profits enough comes from maximizing the total amount of principal loaned to all the borrowers. The purpose of this part of the proposal is to eliminate the problem represented by the cliche` in (C) above. A fee that is independent of interest rates means that the lender need not fear the cost of doing quantities of paperwork; each borrower pays it up-front. Also, as the problem is reiterated in (D), note that the cost of paperwork should include making the assessment of each new borrower, but probably not include a re-assessment of a prior customer. Unless the customer thinks a new assessment will lead to a lower interest rate! Therefore the size of the loan can be completely dissociated from the interest rate, if an appropriate reasonable fee is charged. (Currently, quite a few fees can be associated with a loan, and some simplification may be in order.)

(2) Let the interest rate on the loan still be determined on a basis of risk. No change to the existing system, for making that determination, is being proposed here.

(3) Let there be a relaxed repayment schedule for the principal. Obviously the lender does want the loan to be repaid before the borrower dies, but less obviously, the lender might consider not wanting the principal returned until the borrower dies! A long-lived borrower, paying interest reliably for a lifetime, is just exactly someone from whom the lender will profit most!

III. Ramifications of (3)

(a) A relaxed payment schedule for the principal means that only the interest must be reliably paid, after, say, the first year or two. The consequent reduced size of each regular payment, compared to traditional loans offered by another lender, should attract customers.

(b) Since the principal should indeed be repaid someday, the lender may require the borrower to insure the loan. Current business practice frequently involves this already.

(c) Simply because the borrower may pay only interest and insurance premiums for years, before realizing that those same payments could continue for a lifetime, that is why the lender can reasonably expect the loan to eventually be fully repaid. People don't really like owing other people. This proposal allows the borrower to repay a loan as fast as possible, but the lender is free to say, "There is no hurry." -- thereby setting the stage to earn interest for a long time.

(d) One might think that this proposal will remove vast amounts of money from the pool available for loans. But lenders are always adding part of the interest they earn back into that pool, for new loans, to grow their business. This proposal primarily reduces the "turnover" of principal, from one borrower to the next; the lenders naturally benefit from long-lived loans. And remember that insuring a loan means that no principal should ever be truly lost from the pool.

(e) Different people have different preferred approaches to repaying a loan. Here it is proposed that the borrowers pay whenever and whatever they want, as long as each month the lenders receive the minimum interest amounts. Perhaps for the first year or two, the lender should encourage payments over and above the minimum, to create the financial situation that this proposal is all about. Certainly the lender always knows how much the next payment should be, and the borrower at least knows the original required monthly interest payment. Well, any excess should at first be treated like a partial advance payment. Eventually the excess adds up to equal a whole advance payment, after which all excess goes toward the principal. This single "virtual" advance payment offers a kind of protective buffer against unforseen circumstances. The borrower should accept this, to gain the other side of the coin, as described below.

(f) It is important to keep in mind that the lender originally made the loan knowing that interest on the full amount could be reliably paid. Now consider that any borrower who is repaying the principal is someone who, regardless of the type of loan, eventually builds up a unique kind of "equity" relative to the original amount borrowed. The required interest payments are reduced, yet the lender knows that the borrower could still pay the original amount. Think about how ordinary equity, in the home mortgage business, can be turned into a second mortgage, with an extra pile of paperwork. It is proposed that the lender consider any unpaid amount of any loan to be a "floating principal" amount. Why is it necessary to insist that the principal be paid down, inexoribly and mercilessly? Remember that the lender just has to find someone else to borrow that repaid money! So relax! Thus, if the borrower runs into unexpected financial trouble, which could make a regular interest payment impossible, well, there is that virtual advance payment to help. If the economic crisis continues, and if the borrower has "floated down the principal" sufficiently, as compared to the original loan amount, then it should be possible for the lender to say, "OK, we'll just take your scheduled interest payment out of that equity, and your next required interest payment will be larger, simply because the principal will have floated back up toward its original amount." Here it is obvious that the "equity", or repaid principal, must at least be equal to a minimum payment.

IV. Subramifications of (f), assuming the principal has floated downwards sufficiently

(i) The temporary inability to make a scheduled payment is not a rare event in the industry, but it no longer has to be automatically associated with rancor between lenders and borrowers, or worsened credit ratings for borrowers. That should make this type of loan even more attractive. Meanwhile, of course, as the principal floats back up, the lender actually benefits from an increased likely total lifetime of the loan, with automatically-associated additional interest payments -- and no extra paperwork! These facts should encourage lenders to make such loans, and encourage borrowers to experience as few problems as possible in payback. (Borrowers have to rebuild that virtual advance payment before they can continue floating down the principal.)

(ii) Another payment problem has to do with being on time. Although this type of loan relaxes the payments against the principal, the lender cannot relax its need to be paid interest in a timely manner. Nevertheless, here again is where the effort to float down the principal prevents rancor. That virtual advance payment will be there to buffer any ordinary lateness! And when the payment does arrive, it merely becomes the next virtual advance payment. Never again can any payment be called late; amounts due are either paid or not-paid -- or, sometimes, insufficiently-paid. The last two cases merely lead to automatic extractions from the equity, and an informative note from the lender, as already described. Major warnings should only be sent if the principal floats back too close to the original amount -- the loan wasn't approved for more than that!

(iii) The ability to float the principal back upwards, toward the original amount, is certainly a beneficial thing for a borrower in trouble. However, it should be possible for the borrower to also inform the lender of a voluntary choice along the same lines: "We need some home improvement money, so we will be devoting our next 4 sheduled interest payments to that purpose. We know and accept that you will obtain your payments by increasing the principal we still owe. We also know and accept that our future interest payments, and the duration of the loan, will consequently be increased. Thank you for the opportunity to control our finances so usefully and easily!"

Vernon, Feb 03 2003

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       The largest problem I have with this entire presentation is the assertion that the lending entity should not really care about how long it takes for a borrower to repay his original loan because a) he is guaranteed repayment through a third-party insurer; b) presumably he is fully collateralized with some sort of hard asset (real estate, equipment, vehicle, etc.); c)he continues to reap interest at a specified rate the entire time any portion of the remaining balance of principal is owing.

If I were an institutional lender, I would remind you that my pockets are not infinitely deep. I can only lend monies up to a specific multiple of the cash assets I have on hand at any given moment. I am precluded by federal law from loaning any additional monies out once that threshold has been achieved. Therefore, it behooves me to always maximize the spread of interest rates between the federal cost of funds that I am borrowing money at and the consumer market rate that I am lending money out at. I don't want to be caught holding a lot of long-term low interest loan paper when federal rates are rapidly rising. That severely pinches my bottom line and ability to write new loans at higher market rates.

But what about the collateral, you say. If the borrower defaults, the bank can just foreclose and and take the property. But everyone knows that if the property had not declined in market value already, the borrower would have substantially less incentive to let the loan default and walk away from the property. Even hard assets cannot be counted on to keep their value through economic downturns, and banks are not meant to be in the real estate investment business as part of their charters.

And in the very worst of times, can we really count on the huge insurance company re-insurers to bail out all the insurance companies that are bailing out all the banks that are failing because you and I can't find a job in the midst of a major depression?... It all begins to look a bit like a big house of cards if you look at it too closely for too long. And that's definitely one house that is going to be tough to finance if the nation backing it doesn't stand tall in the opinion of the world.

That's my two cents towards the loan payment. Oh, and by the way, you meant to use the word "principal", not principle, throughout your idea and its title.
jurist, Feb 03 2003
  

       Hey Vernie man, nice to see you back. Where've you been?
madradish, Feb 03 2003
  

       Do you intend that this method of lending be used in relation to commercial or individual borrowers?
my face your, Feb 03 2003
  

       Bankers deal with principals. They hardly ever deal with principles...
dbsousa, Feb 03 2003
  

       No wow. Lending is a *very* competitive market, and most of the proposals in here are already implemented in one form or another in the marketplace. In fact, the bulk of the proposal sounds an awful lot like credit card debt. Widely Baked, I say.
DrCurry, Feb 03 2003
  

       Re proposal II. (1): For mortgages, this exists in the form of closing costs.   

       I also feel the need to say something about amortization and the role that plays in all of this. Apologies if you have addressed it, but frankly Vernon, there are just too many damn words here.
waugsqueke, Feb 03 2003
  

       jurist, thank you for information of which I was unaware. I corrected the misspellings (old spelling advice, "The principAL is my pal; the principLE is the rule" turns out to be inapplicable to loans.) Still, a couple of your points are perhaps refutable. For example, why would a loan need BOTH full collateral and a full coverage by an insurer? Some combination should be sufficient for the lender.   

       Next, while I don't know the statistics, I find it difficult to think that ALL loan-defaults involve people who have given up on their property. Sure, I know that some portion are due to con-artists at work, but I thought most were due to sad economic situations, such as extended unemployment.   

       Regarding the borrowing that lenders do, I confess to being a little unclear on the involvement of Federal money. Many lenders are ordinary banks or credit unions, and it is obvious why they can't loan out all the money that gets deposited -- they have to have a significant amount of cash on hand for day-to-day business.. My question regarding Federal money is most simply stated, "If we have this huge National Debt, then how is it that the Feds can loan out any money at all?" I've always wondered about the "Fed" setting interest rates for (imaginary?) money they lend out!   

       Another aspect of the preceding is your implication that the money lent by the Feds doesn't have a fixed rate, while the ordinary lenders do offer fixed rates. I really doubt that that is the case, since ordinary Savings Bonds ARE fixed-rate loans (by the People to the Feds, to be sure, but it means that the Feds DO do fixed-rate stuff, along with VA or FHA fixed-rate mortgage guarantees). So, if the money borrowed by the middleman-lenders, at, say 4%, is in turn lent out at, say 6%, both rates being fixed, then it doesn't matter at all if the "Fed" rate suddenly goes up to 8%, with the middleman-lender wanting to do loans at 10%. In either case the lender makes exactly the same 2% difference, as earnings, so it doesn't matter if the old 4%/6% loan persists for 50 years.   

       Finally, regarding the very worst of times, well, sure, everybody has problems then. I do think that something I wrote in the main text [III (C)] you perhaps didn't think about enough. What AMOUNT of premium will the insurer charge, to cover the chance that the loan will never be repaid? The risker the insurer thinks this is, the higher that premium will be! From the perspective of some borrowers, the ordinary loan with built-in principal payments might seem to be a better deal! And most people really do prefer not to be in debt, especially if they've been there for a long time. Many have horror stories of, for example, "rent to own", a variation on the theme of typical debt, in which a $500 TV might have cost them $2000. Thus I think that most people will not be slack in paying back the principal, most of the time. The main idea here is to ALLOW some slack in the merciless current system.   

       madradish, I've been working a lot, not getting enough sleep, and have just not had enough spare time to play here very much.   

       my_face_your, this proposal was deliberately written to be generic. Let the borrowers and the lenders decide together whether or not some such system is workable for them.   

       dbsousa, yes. That's why this is about a merciful loan.   

       DrCurry, regarding credit card debt, I do see the resemblance. But credit cards are worked from the bottom up, not usually from the top down, as desribed in the main text (they aren't ALWAYS maxed out as soon as they are in the hands of customers). Simply because credit card debt tends to creep up from small beginnings, it is those small beginnings that let the lenders associate the cards with high interest rates. Nobody would WANT to max out a platinum card, at those rates, to buy a house!   

       waugsqueke, I did mention in the main text that there are a lot of fees already associated with current loans. Too many, in my opinion. And "amortization" is, I think, just another way of saying, "pay back the principal".
Vernon, Feb 04 2003
  

       Thanks Vern, try and catch up on that sleep. Deprivation's a killer (she says tiredly).   

       If this is your play I'd hate to see your work!
madradish, Feb 04 2003
  

       //Let the borrowers and the lenders decide together whether or not some such system is workable for them.// Fair dos. I can't see it being too popular with individual borrowers, though - it lacks simplicity.
my face your, Feb 04 2003
  

       Ouch. Are you a lawyer? Real estate agent? But seriously, one thing I DO like about this idea is NO MORE LATE FEES. When I was a misguided youth, I had a credit card debt of 200.00 - there was a late fee for a late payment, and that fee took the card over the credit limit, so they added an over-the-limit fee, and that took the total amount JUST over what I was able to pay off or reliably pay. In the end, I wound up with 1800.00 debt from 200.00 original principal.
By your system, if I understand correctly, they would simply have said "No problem, pay just the interest, and pay on the principal when you can." and there would not have been an over the limit fee or late fee.
This brings me to a brief and simplified rant on the subject of lending and borrowing from financial institutions; to wit - Banks need you to deposit money with them in order for them to have money to invest in various ways. Banks need you to borrow money from them, so that they can charge interest on the loan and make money that way. Therefore, we who deposit money or borrow money from a bank are doing them a BIG favor, and they should treat us that way. [climbs down off soapbox]
submitinkmonkey, Mar 23 2005
  

       Thank you.
Vernon, Mar 24 2005
  
      
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