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Using credit: Subsidy 2 – low level borrowers

Tuesday, 1st Jun 2010

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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.