Why are there loans at rates lower than long-term economic growth?

Question

Long-term economic growth is said to be between 8 and 10%/a, yet people get loans for houses at 3.5%/a and loans for random stuff at 5%/a. I kind of understand that people get loans for houses at rates lower than the growth rate of the entire economy in the long run because maybe houses are more stable in value than the stock market and banks are playing it close to the edge / there are regulations that state that banks may not use money they borrowed from their customers or the central bank to buy stocks or index funds.

But why do people get loans at low rates for random things where they don't even need to state a reason or for things that clearly depreciate quickly, like for example cars? An individual could play the long game and win by taking out loans at low rates and buying index funds from the borrowed money.

There even is extra ridiculous stuff I keep coming across like for example this offer where you actually pay less in interest than what they will give you as a bonus. Their rates even start at 2.9%.

My gut feeling tells me that it probably is a stupid idea to take out a loan unless you "need" one and that wanting to invest in the financial market is in no way "needing" a loan, but shouldn't banks themselves be playing the long game? Why are they enabling others to play the long game at a profit at their expense?

Answer 1

I am presuming that your reference to long-term economic growth being between 8% and 10% is in reference to returns from the US stock market, usually the S&P 500 (which has an average rate of return of 10.69% over the last 147 years -- S&P 500 calculator).

Banks make all sorts of investments that are not equities, however, for a number of reasons.

1. Fractional reserve banking. The primary reason is that banks are allowed to loan out more money than they actually have (in the United States, they can lend roughly nine times as much money as they actually have.

2. Risk. The stock market is risky and volatile. A long term rate of return is just that -- long term. In 2008, the rate of return for the S&P 500 was -37.22%. Those returns did eventually return, but that doesn't help if the money is needed short term.

3. Timeline and predictability. Absent a default on the loan, it is a dependable revenue stream that can be accounted for in advance. A bank can forecast its expenses -- payroll, other operating costs, expected withdrawals, etc -- and needs money to cover those. Equities are not a good short-term investment. (This is also why investors have bonds or even cash reserves in their portfolio -- the reduced growth brings reduced volatility.)

Answer 2

It's a little challenging to answer this, because it seems like you are basing your question on unstated assumptions about how lending rates are set. And, you're comparing apples to oranges. In fact, you're really comparing an apple to the orange farming industry. Not only are the products different, but the scope is different. To me, this reads about the same as saying "why do people at the grocery store pay $4 for a gallon of milk, when cheese futures are currently priced at $2 wholesale? After all, they're both dairy!"

Yes, they're both dairy, but they're different products, on very different markets. Buyers aren't cross shopping those things on those markets. Buyers for those things on those markets aren't even typically the same entities.

Loans are priced based on expected risk of a specific borrower for a specific product with specific terms. Banks consider their own portfolio, their lending strategy, marketing strategy, and indicators about a particular borrower. Banks consider costs of funding a loan (how/where the cash for the loan comes from), the cost of reserving against potential loss (which is how "risk" is monetized), and the cost of servicing the loan (paying for customer service staff, computer systems and infrastructure, etc.) "Economic growth" isn't really even directly in the equation, except as it influences cost of cash (indirectly) and even more indirectly how it influences models used to calculate reserve requirements.

You asked a few specific questions:

shouldn't banks themselves be playing the long game? Why are they enabling others to play the long game at a profit at their expense?

By asking this, it seems like you're trying to ask, "why would a bank lend money at only X%, when they could instead just go make 8-10% because that's the rate of economic growth?

Asking why a bank would be happy with a product that nets them X% when economic growth is so much higher than that is the same as asking why any other business or investor would be happy with anything else: Why would my local Volkswagen dealer sell me the car I drove to work today for 1% over their invoice cost, when 1% is so much less than your quoted economic growth factor?

Essentially, "Economic growth" (as you're quoting it) is essentially an aggregate of many broader factors, and it's not something you can just go (directly) buy.

Answer 3

The difference is risk.

Fixed-rate loans are "risk-free" in the sense that their "rate of return" (a negative in this case) is known. Equity investments (and many corporate fixed income investments) have expected returns that are higher because the actual returns are variable. Yes economic growth may average somewhere between 8% and 10% (using your numbers), but the actual growth may fluctuate each year between -10% and +20% most of the time and may be as high/low as -30% and +40%. So investors want to be compensated for that level of riskj by requiring more return on average.

An individual could play the long game and win by taking out loans at low rates and buying index funds from the borrowed money.

Yes, they could, but what happens when the market drops 10%? The investor has a loss from the investment and must still make the loan payment, so they are hit doubly, and must have even greater returns from their investment to make up for the loss. If an investor borrows at 3%, and the investments from the borrowed funds lose 10%, then the return the next year must be 18% ((.10 + 0.3 + 0.3) / 0.90) to make up for the loss the prior year plus two years of interest payments. So when you investment on borrowed money, losses can be very hard to recover from, so more expected return is required.

My gut feeling tells me that it probably is a stupid idea to take out a loan unless you "need" one and that wanting to invest in the financial market is in no way "needing" a loan,

Your gut is correct.

shouldn't banks themselves be playing the long game?

Because the banks can't afford the risk that the equity market provides. They must maintain stability in their funds and can't afford to have significant fluctuations in their income. They are perfectly happy loaning money out at lower interest rates because they are lower risk.

Why are they enabling others to play the long game at a profit at their expense?

The bank is not losing here - they are getting compensated by getting paid interest on the borrowed funds.