| @Fiona: Read it. Worth it.
I had some thoughts of my own - or experiments rather. I wanted to see how much you'd need to repay for a loan over 30 years, and how much profit that would be for a bank.
When a bank loans money, it will only get that back after a while. And that's where inflation can be rather nasty for a bank: It devalues money over time. On the borrower's part, inflation is a blessing: It means that a loan gets progressively easier to repay as his salary rises.
If a borrower repays a 10 dollar loan after 30 years, those 10 dollars are actually worth a lot less because of inflation. That's a bad deal for the bank, if they lent out their own capital, and they can't survive like that. I assumed that is why they charge interest. If the interest is higher than inflation, they are making money, so they can pay their staff and please shareholders. This made sense to me.
I was curious to find out how expensive a 4% interest loan would be over 30 years for the borrower. I picked a relatively long period to really see that inflation effect. I realized that the added interest would become less as you were repaying the loan, so I made an Excel sheet, in which I could add interest and deduce the repayment in iterations.
Year zero, the starting loan was 10 dollars in this case. Interest would be 4% all the time, so it becomes $10.40 in year 1. I figured out that if you want to repay the entire loan in 30 equal repayments, you'd have to repay $0.5783 each year. It pays for the interest and a little extra, which will slightly lower next year's interest, leaving a slightly bigger part for loan repayment each year.
At the end of 30 years, you'd have paid $0.5783*30 to the bank = $17.35 . The bank has nearly doubled it's $10 capital, by lending it to you, and waiting for you to do all the work for paying it back. But okay, you had a nice house to live in or whatever it is you managed to buy for $10 in year 0. (Maybe 2 ice creams?) What would have happened when you didn't borrow it, but instead decided to save that amount to an interest carrying deposit (let's say 3%), is that you would have had $27.51 at the end of 30 years. That seems like a lot more, but there will be inflation.
Let's say there's 2 percent inflation. That's not much each year, but it does mean that after 30 years of constant annual inflation, a dollar in year 0 will only buy the equivalent of 55 cents at the end of the period: the value of money has almost halved! But if you had saved up, that would still mean you can buy $15.19 worth of goods at the end, at year 0's rates. One and a half times as much as the guy who borrowed it and spent all that time paying interest to a bank.
However, that inflation also affects the bank. At the end, they have received $17.35 from you, but that is now only worth $9.58. Which means the bank in real terms has made a loss on you: It's capital has decreased in value while they were waiting to get it back from you - by more than they were getting interest from you. While you are repaying the amount, you pay less and less interest. The problem is of course that the amount you have already repaid is sitting still in this isolated example: If they lend that money out again at 4%, they will get the full amount of 40 cents on their $10 capital each year.
But let's pretend you're the only borrower for now. More fun that way. We didn't let inflation work in favour of you, yet. Although it devalues money, you will be receiving more and more salary. At the end of the period, you'll be earning almost twice as much as in year 0. That means repaying your $10 loan can be a lot easier towards the end, as a percentage of income. On an annual salary of $3, your constant repayments of 58 cents would be 19.3% at the first repayment and only 10.7% at the end, when income has risen to $5.43 for the same job. What you can do is to reserve a steady percentage for debt repayment to make it a little easier on yourself at the start. You'd have to pay slightly more towards the end, but you are earning more money then.
For the same length and interest, that steady percentage would be at around 14.8%. Your first repayment would be only $0.453, leaving you with roughly 12 cents extra to spend that year. Your last payment will be almost double that: about 79 cents. However, compared to the level repayments, you are not building off your loan as fast at the start, so you will accumulate more interest. As a result, even though this loan is easier to repay than the other one, it will cost you a little more. In the end, the bank will receive $18.37.
That is good news for the bank: With the inflation that money is still worth $10.14 in year 0's value, when they lent it. They made 14 cents over 30 years without having to do much for it. A 1.4% profit over 30 years is not going to make them rich off just you. So, again, they would do good to keep lending the pieces you repaid to others. But since I decided a little earlier that you were going to be their only borrower, they'll just have to forget getting rich off their bank.
I also decided to see what happens if this country suffers from a more inflation. All the other variables are equal. Inflation is a very respectable 6%. As we know (from the posts above, if you're like me), inflation is very nice to borrowers. We'd expect you to pay a smaller percentage, as your income will rise much faster towards the end of the period. And indeed, your payments as a percentage of income falls to ~8.2%. During the period, your salary will have gone from $3.00 to $17.23. Something interesting happens the first years, though: your loan will increase because the repayments are not enough to cover the interest. The first year, you will repay only 26 cents, while interest is 40 cents. Next year, interest will be slightly higher, because you have a higher loan, and it will increase further. Until about the 10th payment, when your salary will have increased enough to repay the interest on your loan, which is by then $10.78. From there on, the loan will start to decrease faster and faster.
That obviously means you will be paying more to the bank. In total you will pay them $20.51: But with significantly less impact on your wallet. Despite the increased payment, the bank will not be too happy. After 30 years of 6% inflation, a dollar will be worth only 17 cents. Meaning that your total payment of $20.51 is worth only $3.57 in year 0's value, when they lent you $10. That's a horrible loss. Unless...
Leverage.
I have just seen the documentary film Inside Job. One of the statistics they showed was the leverage that some of the largest banks operated with. Leverage is when you are allowed to use real assets to borrow/lend a lot more money. So for example, you can use $1 (as collateral), to lend out $3: the leverage then is 1:3. For the banks they showed in the film, leverage was between 1:25 and 1:33. Let's take the lowest one for our bank. At 1:25, they would need only 40 cents to lend you $10. If, at the end of the period, you only give them $3.57 worth in return, they still multiplied their capital by a factor 9 almost. In fact, if they would charge no interest at all, they would still more than quadruple the value of their 40c capital by lending $10 to you. It's one of the benefits of magic money.
If these banks figure out a way to lend their entire capital, with the leverage, to people who repay it in a year, they get pretty close to multiplying their capital value by 25 each year. Might be possible with 1 year micro-credits to farmers for example. Even if half of all the farmers who get these credits default, you're still making 12,5 times your investment. Literally making it. It was virtual money when you lent it, and you get real money in return. The only difference with printing money is the guy who issues it. If it's governments it's bad, but if it's private interests - meaning rich bankers - , then it's great.
We are told that printing money leads to inflation. Maybe the only reason we didn't get the massive inflation you would expect through this leveraging trick, is because trickle down doesn't work?
Edited by Vninect - 27/11/2011, 16:52
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