Monday, September 9, 2013

Lending is good and bad

I was once told by a person I very much respect that I had an aversion to taking out loans. I suppose in the climate of free loaning (free as in loving, not as in beer) that persisted until about 2007 I did seem loan-averse to most. I thought it imprudent to view the rise in the value of a house that served as a home as a real increase in wealth. I thought it doubly imprudent to remortgage on such an increase. I warned a friend in 2002 not to take out a mortgage for nine times his salary. I didn't like the fact that a new generation of students who came after me viewed it as normal to start out one's working life in debt.

But of course I have taken out loans. I've taken out mortgages for houses. I took out a loan fifteen years ago to buy a car. Taking out these loans made sense. The mortgage helped me get on the housing ladder in 1995, which in the long run has allowed me to spend a surprisingly small amount to live in a decent home. The car was different - it was a necessity to allow me to get to work and so the loan and depreciation were unavoidable at the time.

But I would have preferred to avoid these loans because if I had the money to buy the house or car outright I'd have saved tens of thousands of pounds over the years.

So now, with the UK's economy still bumping along the bottom, as it has for several years, it might surprise some to hear me say, "yes, borrowing money to spend money is a good way to get the economy going again". The immediate retort of many is to say, "if you're in debt, it's stupid to take out more debt to pay it off." It may or may not be stupid, depending on what you do. Let's take familiar example of debt - that associated with buying a house.

A person wishes to take out a loan to buy a house to be the family home. They borrow £200,000 at a 5% interest rate and use that to buy the house. This loan is perfectly sensible (aside for possibly inflated house values) because a home is a necessary thing. The person is essentially renting the £200,000 required to purchase the home by paying £10,000 in interest per year.

Some years later they decide to remortgage for the same amount but at a 4% interest rate offered by a different lender. This means they take out the loan from the new lender and the money from that goes to pay off the original loan. This is a clear example in which taking out a new loan to pay off an existing loan is a good idea because now the cost of the £200,000 loan is only £8000 per year.

But let's imagine when it comes time to remortgage that house prices have increased and the house is now worth £250,000. If they decide to remortgage at 4% then they will be left with £50,000 to spend and still be paying £10,000 per year. This seems like a good deal, the cavaet being that if house prices ever drop and they spend their £50,000, say on a luxury car, then they might get stuck in a negative equity trap one day, i.e. their house can't be sold to pay off the £250,000 loan.

But a person who is prudent with money would take that £50,000 and invest it. In that way, they will get a return on that new money and they'll safeguard against the negative equity trap. Let's say this prudent person buys some government bonds (a safe investment which is in fact like lending money to the government) which lock the money up for 5 years but give a return of 5%. This person has increased their mortgage but is making money on the extra £50,000 they borrowed: it was borrowed at 4% and invested again at 5%. Again, another example where borrowing is a sensible course of action.

Now let's consider a different example, a business. Let's say this business has a factory that produces chairs. Suppose each chair costs £50 in material and labour to make and can be sold on for £100, making a profit of £50 on each one. If they make 100 chairs in the month, the profits are £5000. The chairs are good quality and in high demand and they have no trouble selling them and are sure they could sell more. But, there's a problem. The factory's fixed costs are £5000 a month (rent, administration etc) so they're only breaking even and can't save up any money to expand their operation and actually become profitable. The obvious solution is to take out a loan and any bank that's half-way decent would be willing to give them that loan, all else being equal.

But it will only make sense to take out this loan as long as the interest payments it incurs are less than profits of the newly expanded business. So let's say £200,000 is borrowed at 5%, i.e. £10,000 of interest needs to be paid per year. Clearly, this will only be worthwhile if overall profits are £10,000, at the very least, which means they'll have to sell at least 200 more chairs per year, and probably a bit more because the fixed costs will rise. If this investment increased their production to, say, 150 chairs per month, then the business will almost certainly become profitable.

The business example again demonstrates that taking out a loan can be a very prudent thing to do, in the right circumstances. This example is of course very well known and is sometimes referred to as gearing, by analogy with changing the gear to keep an engine working in an efficient range of revs: if the factory drops below its current output it will lose money and "stall".

The common element that exists in both the household loan (mortgage) example and business example is that the loan is only worthwhile when the interest that you need to pay on it is less than the return from investing it.

So in the UK economy, if you can borrow money cheaply at the moment (which the UK certainly can) then it is not a stupid thing to do if it is wisely invested into the productive economy. To put it simply, the UK can borrow now and borrow cheaply because interest rates are low: the Bank of England base rate is 0.5% at the time of writing, and it has been at that rock bottom for years now. It is not hard to envisage that this borrowed money can be invested to bring back a return above that base rate of 0.5%. If done sensibly, it can create jobs, fund affordable houses and more.

There's plenty more to say here, such as on the control of currency, money creation and the issue of inflation, but I'll leave that for another blog post. My main point is that borrowing is an economically sensible strategy in the right circumstances. Also, as a wee corollary, it's surprising how much of the unproductive world of banking starts to make sense once you realise there are profits to be made by borrowing money so you can lend it out again at a higher interest rate.

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