Using Credit: Subsidy 2 – Low Level Borrowers
In society at any given time there will be people who are in
different financial circumstances who have different levels of debt relative to
their assets.
For many varied reasons, there will be many people in society who
have no debt at all. Perhaps they are in their 50's and have paid off their home
and have no leveraged investments. There will also be people who have low levels
of debt relative to their asset levels. There will be some people who have a
relatively high level of debt compared to their asset levels. A bank or
financial institution will have loans out to the entire spectrum of
borrowers.
Assume a person owns their home worth approximately $500,000 and
they have a loan of $50,000. What
risk do you think the bank or financial institution is at of not getting their
money back on this loan? Almost nil I'd suggest. If someone owned a property
worth $500,000 and they had a loan of $250,000, what risk do you think they are
to the bank or financial institution? Very little I would suggest. If they
stopped the repayments the bank or financial institution has enough of an equity
buffer in the secured asset that even in the event of a fire sale the property
would have sufficient funds to cover the repayment of the
loan.
If someone owned a property worth $500,000 and they had a loan of
$400,000 what risk do you think they are to the bank or financial institution?
There is some risk to the lender. If they stopped paying the loan and let the
property go to ruin it is quite possible that the lender could lose some money.
If you were lending money, wouldn't you much prefer to lend to the person who
owes $50,000 on the $500,000 home rather than the $400,000? Wouldn't you be
expecting a higher rate of interest on the higher level of borrowings to
compensate for the extra risk?
While there is a larger risk to the lender by lending $400,000
versus $50,000 against a $500,000 asset, the financial institutions rarely
charge different interest rates to different borrowers. The lender knows that
across the board they will have a range of people at different levels of debt
and in order to be able to offer a competitive interest rate they typically
offer one interest rate across the board. They know that if the economy went
into a severe recession and property prices went down, there are enough
borrowers who have low levels of borrowing that the lenders potential bad debts
would not become too significant.
What do you think would happen if everyone borrowed up to 80% of
the property value and kept it at that level? Suddenly the lenders would have a
much riskier portfolio on their hands and they would have to increase interest
rates to compensate for the risk. If the economy went into recession there is a
chance that a high percentage of loans could go into default and the banks may
lose significant amounts of money.
Those who borrow to a lower level relative to their assets should
really be getting a cheaper interest rate than those who borrow to a higher
level. Lenders have never been able to figure out a way to effectively price the
different risk on property loans. They typically use the arbitrary figure of 80%
loan to value as the point where loans become more risky. They don't
differentiate between 5% borrowings and 79%. Fortunately for highly leveraged
borrowers, not everyone borrows to their maximum. Those who borrow to lower
levels relative to their assets are effectively subsidising those borrowers who
take higher risks and borrow towards the
maximum.
For more information on how Momentum Wealth can assist you with
your loan needs, con
Finance Broking Services are provided by Momentum Wealth Finance
Pty Ltd*.
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