Lending Money


There’s all kinds of reasons why people want to borrow money.  Mostly, though, there are two:

  1. They need the money now.  A bill has to be paid or service will be turned off.
  2. They want something now.  A purchase is to be made and saving the money isn’t desirable.

In any case, an individual is taking current value of money in trade for some future value of money.  And current money is more valuable than future money; I’d rather have $20 now than $20  later.  So, to compensate for that, money lenders charge interest.  While I would rather have that 20 bucks now, I might be willing to hold off if I could get 25 bucks next week.

For that reason along borrowing money to spend now is going to cost more money  later.  The other factor that raises the cost of borrowing is the real possibility that the guy doesn’t pay off his debt.

I might be willing to float my friend 1 hundred bucks confident that he’ll be paid on Friday and be able to return that money.  However, a guy at the bar who isn’t working is certainly less likely to be able to repay that money.  Consequently, I’m equally less willing to lend him that same $100.  Now, if you’re a bank, and you’re faced with lending $100 to 100 people, you quickly are able to identify a number of those folks who’ll default.  And the cost of borrowing goes up with the risk.

To further complicate the process, there exits a method of borrowing money for a specific purpose; a car or a house.  With loans involving amounts of money this large, lenders have found that the risk associated with default goes down as the amount required for a down payment goes up.  There exits skin in the game.

Care to guess what happens as that down payment amount goes down?

Bubbles and crashes, bankruptcy and foreclosure.

 

Looking at the graph above and thinking back on the housing boom, it would seem that 20% is about right when it comes to a down payment.

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