FINANCING LIFE
Fall 2015
Session #2
“Credit and Debt”
To “borrow” is to reach into the future to pull some future income back into the present. When doing so
it is important to remember that money doesn’t travel through time dollar for dollar. The dollars “lost” in
the future, because of interest, will exceed the number of dollars that are usable in the present. The longer
the time period and the higher the interest rate, the more future dollars “shrink” as they are brought into
the present. Debt is always costly. It should only be undertaken when there are real benefits that exceed
that cost.
Prospects and Purpose
Whether it makes sense to bring income into the present and spread payments out over the future
really depends most on prospects and purpose. What do your realistic future income prospects look
like? If you are highly likely to sign a $40 million pro sports contract in six months it may make
more sense to borrow than if you are about to retire and expect your income to be cut in half.
For what purpose are you seeking to move income into the present? Is it to acquire some long-lived
and seldom purchased asset like a house, or are you borrowing to pay for expensive dinners at fine
restaurants. Regularly reaching into the future to pay for current consumption expenses is a sure path
to difficulty…(unless that $40 million movie contract is a sure thing.)
Security and Risk
Lenders are betting on your actually receiving the future income that you are both anticipating. As a
result they face a real risk that you will be unable to pay them back if the income does not materialize.
The greater the size of the risk they perceive, they more they will charge you for the loan. They will
try to control that risk in two ways. The first is by gauging your future income prospects and your
likelihood of paying back the loan. They will examine your employment history and prospects and
rely heavily on your “credit score” a number derived from your credit record. If there are problems
with either of those, loans will be harder to get and more expensive. If you have no real record,
lenders may require a “co-signer” in order to make a loan. The second way to reduce risk is to
“collateralize” it by having you pledge some valuable asset as security, e.g., title to your house or
your car. By requiring a down payment they loan you less than the full value of the asset
(Loan/Value ratio < 1), thus they further reduce their risk.
The Structure of a Loan
Once you have determined that debt makes sense for some purpose or period you should try to
acquire the funds in the cheapest way possible. Loans have a number of defining characteristics that
should be considered before deciding how to borrow:
Principle:
The amount of money lent (and borrowed)
Term of the Loan:
The period of time between borrowing and paying it off completely
Payment Schedule:
Are payments due annually, monthly, biweekly, etc.
Annual Percentage Rate: The interest payment on the loan, calculated according to strict rules
so that different loans can be compared in terms of interest cost
Amortized v. Interest Only The payments on an amortized loan cover both interest and principle
so at the end of the term nothing else is owed. An interest only loan
consists of paying the interest in installments while the principle is
not due until the end of the term when it is all due in a lump sum or
“balloon” payment.
Total Finance Charge
The cumulative sum of all the interest paid over the life of the loan.
Tax Treatment
If the interest deductible, thus lowering the net cost of the loan.
Inflation and Debt
Finally it is important to remember that not only does the number of dollars change as income is
transported across time, but also the value of each dollar can change because of inflation. In general
the real rate of interest is equal to the nominal rate of interest minus the rate of inflation. Thus if you
take out a loan at 6% when inflation is 2.5% the real cost of the loan is 3.5%.
Sponsored by the Center for Women & Financial Independence