Friday, May 31, 2013

How can a Bank Make Money on 0.9% Interest

As someone who works in the lending field, I often find it shocking that financial institutions can make any sort of money with interest rates as low as 0.9% (I’m thinking car loans here).  Intuitively, this doesn’t make any sense.  If your interest rate is lower than the inflation rate (usually between 2-3%), how can you make any money off your loan?  Well, banks are smarter than you think.
First, consider how a bank makes money; it takes your checking and savings deposits for essentially free (you get the guarantee that your money is safe), and it loans out your funds to people who need mortgages, car loans, etc.  This is a pretty nice little game of arbitrage here.
The second interesting thing to think about is how a fully amortized loan is structured.  If you have a fixed loan, you pay the same amount each month, however the way a bank structures the payment varies throughout the life of the loan.  Your monthly payment is almost entirely interest the first couple years and almost entirely principal the last couple.  Think about this example:  you take out a $20,000 car loan for 60 months at 0.9%.  In the first year, you will pay $432.86/month, but your total interest portion for the year will be $2,005.20.  If you divide this total interest by the average monthly balance, you have an average interest rate of 10.8% for the first year.  Now say, year two comes along, and you decide to pay off your loan: the bank gets its money back and loans it out again all the while making 10.8% interest the first year.  This is why banks eventually encourage you to prepay your loans.  Inflation will eventually catch up to the payment. 
So, what should you do as someone with a car loan?  Well, there is not much you really can do?  If after 12 months you decide to pay off your loan, you will have essentially paid $21,921.77 in today’s money (assuming a 3% annual discount rate) for the privilege to borrow $20,000.  If you went through the full term of the loan, you would have paid $24,089 in today’s dollars.  Borrowing money has a price to it, so the best advice would be not to get into debt in the first place.  The contrary point is that if you can’t get to your primary source of revenue, because you don’t have a car, then the cost of inaction is far more than the debt load.
Whatever you choose, it’s important to realize what you are getting yourself into and how the bank is going to make money off of you.  You will then be able to make smarter life decisions if you are armed with this knowledge.
Wonderful Moment of the Day: The smell of fresh cut grass makes me believe that summer is finally here.

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