College of Agriculture and Life Sciences. Academics. Research. Extension

Perspectives Online

« Workshops Focus on Development, Water Quality | Main | Endowment Creates Feed Milling Scholarship for N.C. State Students»

YOU DECIDE: Why must we pay interest charges?

April 06, 2007

By Dr. Mike Walden
North Carolina Cooperative Extension Service

MEDIA CONTACT: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu

Dr. Mike Walden
Media representatives: For a black-and-white or color copy of this photo, call 919.513.3127 or e-mail dave_caldwell@ncsu.edu.
There's been more bad news recently about the housing market: Home foreclosures are up; thousands of higher-risk homebuyers find the mortgage loans that got them in the door now pushing them out.

Most of these loans carried adjustable interest rates. When interest rates were lower three or four years ago, the buyer could qualify and make the payments. Now these interest rates have adjusted higher and, unfortunately, many borrowers' incomes haven't, meaning they can't make the payments and have to leave their homes.

This is the sub-prime (meaning "risky") mortgage market problem, and many economists (like yours truly) and other financial experts warned it could occur when super-low, and unsustainable, interest rates were offered earlier this decade. It's understandable that folks anxious to buy a home often only look at current costs and ignore long-run expenses. It's an easy trap to fall into, and government regulators are investigating whether more legal safeguards are needed.

But here's a bigger question: Why is interest even charged at all on home mortgages or any other type of loan? Clearly these charges make loans more expensive and, it can be argued, the interest expense is a big reason borrowers sometimes have a difficult time making their loan payments.

For example, if you borrowed $100,000 and repaid the loan over 30 years with no interest, your equal monthly payment would be $277.78. But if you were charged 6 percent interest, the monthly payment would jump to $599.95, and the total repayment over 30 years would be $215,838, more than twice what you borrowed!

I'm sure you're thinking, "This is a rip-off, a total rip-off!"

But let's step back and look at the economics of lending. And to do this, let's put you in the position of the lender. Suppose someone wanted to borrow $1,000 from you and repay it in 10 years. Wouldn't it be fair to simply ask for the $1,000 back 10 years from now?

One problem with that deal is that the economic world likely won't stay constant over this decade, and specifically, prices won't stay constant. Rising prices, or inflation, make future dollars worth less. An average yearly inflation rate of 3 percent would make $1,000 10 years in the future worth only $700 in purchasing power. So loaning $1,000 today and getting $1,000 back in a decade is really like being repaid $700 when you take inflation into account.

Another issue is human nature. Most of us would rather have things now than wait for them; it's just the way we're wired. Having things we like now means we can enjoy them for a longer period of time. It also means we won't miss this enjoyment if something causes us not to be around in the future.

Then there's the matter of risk. There's a chance health or job issues may prevent the borrower from repaying all or part of the $1,000 loan when it is due.

So these three issues -- inflation, our desire for immediate gratification and risk -- are three factors that make a simple transaction of loaning $1,000 now and getting $1,000 back later more complicated. In fact, without the lender's charging for these factors, few loans would take place.

What form do the charges take?

Simple. They're all incorporated into an interest rate. Lenders will attempt to forecast the future annual inflation rate and have it be one element of the interest rate. They'll add to it an interest rate to account for the cost of giving up use of money now (usually 2 percent or 3 percent), then finally include a price for the risk of the borrower. This final piece will be lower for less-risky borrowers and higher for more-risky borrowers.

Therefore, by this logic interest charges aren't some unfair expense used simply to get more out of borrowers. Instead, interest charges are really compensation for the costs borne by lenders.

You decide if this makes sense, maybe by putting yourself in the shoes of a lender!

-30-

Dr. Mike Walden is a William Neal Reynolds Professor and extension economist in the Department of Agricultural and Resource Economics of N.C. State University’s College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The Department of Communication Services provides his You Decide column every two weeks. Earlier You Decide columns are at http://www.cals.ncsu.edu/agcomm/writing/walden/decide.htm

Related audio files are at http://www.ces.ncsu.edu/depts/agcomm/writing/walden/index.html

Posted by Dave at April 6, 2007 09:44 AM