Thursday, June 21, 2012

Understanding Debt and Interest


On Day Two of Project Be's Financial Literacy Workshop on Saturday, I will discuss the concept of debt and interest to our Filipino domestic worker participants. Again, in the interest of hitting two birds with one stone, I will try to articulate my approach in this post; then maybe you guys can give a feedback or two at the end.

In trying to understand debt and interest, we need to look at debt transactions from the points of view of both the borrower and the lender. It would also help if we treat capital or funds as a "good" that people want and/or need, the same way people want and/or need things like food, clothing, and iPhones.

When people don't have enough money for things they want to spend on--a brand new washing machine, an Ateneo education for their kids, or a new business, for example--they almost always turn to debt for additional funds (unlike businesses which can also seek equity financing). And as more individuals and households borrow money, the demand for debt-as-a-good rises correspondingly. Accordingly, people with excess income and savings have the means to lend funds to those who seek it; the more people save, the greater the supply of funds available for financing.

Interest as the "price" of funds

In its simplest sense, interest is the price a borrower pays the lender for the use of the latter's funds (and interest rate is just interest relative to the borrowed amount). And just like any other good, this price is determined by the demand for and supply of excess funds: the more people seek funds, the higher interest rates are; the more people generate savings, and consequently, funds available for lending, the lower interest rates should be.

To illustrate, say person A has 100,000 pesos that she does not plan to spend until after one year. Person X, on the other hand, needs 100,000 pesos now. X approaches A to borrow the 100,000 pesos and promises to repay the 100,000 pesos after one year. If A fully trusts X to live up to his promise, then she may very well agree to lend him 100,000 pesos at zero interest.

What if another person, Y, also needs 100,000 pesos and approaches A to borrow the amount. But unlike X who only promises to pay back the borrowed amount, Y promises to pay back 110,000 pesos after one year. If A trusts Y the same way she does X (you'll see later why this is relevant), then clearly her best move is to lend to Y. But if X needs the funds badly enough, he can make a counter offer that is higher than Y's offer; X and Y can continue bidding the interest up until it goes beyond the ability of one of them to pay. Here we see how the additional demand for funds may drive the interest rate upward (much to the delight of lenders like A, of course). Similarly, when there are more people with funds to lend relative to borrowers--when the supply of funds is high--borrowers like X and Y can shop around for lenders with the lowest interest rates. When more people are capable of lending money, A will have to accept possibly lower rates offered by borrowers. Whatever the case, generally the demand for and supply of funds determine the level of interest rates.

Interest = opportunity cost + risk premium

In the example above we have excluded certain factors may steer interest rates away from the level dictated by market forces. One such factor is the availability of investment opportunities. For example, if A believes that she can easily earn 15% per year if she invests her money instead, then it won't make sense for her to lend her money at a rate that is less than 15%. If A lends her excess funds, she will lose an opportunity to earn 15% from another investment; we therefore say that the opportunity cost to A if she lends her money is 15%, and that this should be the minimum interest rate that she should accept.

The nature of borrowers--specifically their ability to repay their financial obligations on time--also affects the level of interest that lenders demand. Say A is an experienced lender who typically lends at 10% per year, as dictated by her opportunity cost. Say she suddenly realizes that a group of her borrowers has been unable to pay its loan on time one out of five times. In other words, if at any given time five people from this group borrows 100,000 pesos each, only four are able to pay the full principal plus interest amount of 110,000 after one year, resulting in a loss of 60,000 pesos. To make up for the higher risk of default for this particular group of borrowers, A may decide to increase the interest rate to a level where she'll break even even if one borrower out of five defaults (What should the new interest rate be? I'll let you figure that out as an exercise). The excess interest rate A will now charge "riskier" borrowers is called the risk premium.

To summarize, in this post we discussed debt and how various factors may affect the level of interest on debt. We have learned how the demand for and supply of excess funds dictate the general level of interest rates, and how lenders may adjust this rate based on available investment opportunities and the chance that borrowers will default on their loans. Finally, please remember that this is just a simplified discussion of a complex topic, and so I have deliberately excluded other details like the effects of inflation and the other types of risk involved.

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