Why aren’t amortized loans outlawed and replaced with a more equitable model to the borrower?

Question

I completely understand that banks are in the business of making money and capitalism prioritizes profit above all other values. However why aren’t laws enacted that would ban amortized loans and replace them with something more equitable to borrowers. For example charging borrowers a one time 20% fee for the total amount borrowed. So for a $500K loan the total interest would be $100K or 20% of the loan amount? Isn’t a 20% return on investment profitable enough for banks?

Edit for additional context: I was assuming the 20% fee would be added to the loan amount and then the total borrowed of the loan would be $600K. Then that $600K would be divided into 360 monthly payments of $1,666.67. I totally recognize the bank wouldn’t make as much money but I did not consider the loss due to inflation over the years. I was also trying to compare the 20% flat fee versus current interest rates (7% at this time). At current rates a $500K loan amortized over 30 years ends up costing $697K in interest payments. So I was assuming the $100K interest (20% flat fee) vs $697K interest would be a net savings of almost $600K for the borrower, thus being more equitable.

Answer 1

If you restrict how much profit the bank can make from lending, you'll get less lending. And that will prevent a lot of people from getting loans at all.

If we're talking about a $500k loan, that's normally a loan for a house. The borrower is going to want to pay that back over a long period of time-- normally 30 years today. But let's say that we restricted mortgages to just 15 years since borrowers aren't paying as much interest.

Inflation over the past 15 years (Jan 2008 - Jan 2023) has been about 42%. In the 15 years before that, it was 48% so, yes, that is affected by the post-COVID inflation spike but it's still pretty normal overall. So if the bank wanted to break even with inflation, they'd need to end up with $500k * 1.42 = $710k at the end of 15 years. Plus, of course, they'd need to generate some amount of profit. And they'd need to make enough to cover everyone that ended up defaulting on their loan. Plus all the administrative costs of underwriting the loan, servicing the loan, etc. If they could only make 20% of the loaned amount, they'd be virtually guaranteeing themselves a loss to inflation. No one would make a loan in that scenario.

If you were limited to collecting 20% more than you loaned, you'd probably be willing to lend $500k to a very wealthy person who would pay the loan back in 4 years rather than 15 years. But anyone that couldn't afford $100k+ in annual loan payments would be locked out.

Answer 2

Amortizing loans match how banks receive money and how they pay it out.

When you have a savings account with the bank, it earns a certain interest rate monthly, say 0.5% monthly for a 6% annual rate. If they were to loan that money out, they would need to earn more interest on the loan than they pay in interest (otherwise they would go out of business). So they may charge 0.75% interest monthly, or a 9% annualized rate. The borrower pays a % of the current loan balance every month, plus some principal, so that the entire loan is paid off in 30 years with a constant monthly payment. As the principal is paid down, the amount of interest is reduces, and more and more of the payment goes to paying down the loan.

That's why loans are amortized - to match income for the bank with the interest they pay out. It's actually fair to both parties. You pay a percentage of the outstanding loan balance every month that is reduced as time goes by.

Amortization makes more sense if you think of the interest rate as the amount charged as a percentage of the outstanding amount for each period. As you pay down the loan, the rate stays the same and the interest goes down accordingly. "amortization" is just a mechanism to make the monthly payment constant while holding to that definition of "interest".

One could just as well use a fixed principal amount, which would mean that the payments would start high and get lower as principal was paid off. But that is typically contrary to most people's budgets that increase over time as you get raises, etc.

Isn’t a 20% return on investment profitable enough for banks?

Not if that loan is spread over 30 years. A 10% gross return over 30 years is only 0.3% compounded annually (1.003 ^ 30 = 1.1).

Paying interest upfront would actually be worse for borrowers in many cases, specifically when they refinance or sell the collateral. Suppose you got a loan with a 20% upfront interest fee, and decided to move after 3 years. You'd have paid all of the interest upfront, but only had the loan for 1/10 of the time! Plus, you'd have to get another loan for the new house, and pay interest upfront again!

There are examples of "upfront interest" loans, though:

• Many predatory car dealers do charge interest upfront by adding it to the total amount owed, so if you finance a $10,000 car, you actually borrow $15,000 and have to pay the whole amount back even if you sell the car early. These are often geared to less creditworthy borrowers that they assume will not pay it back, will repossess the car and sure the borrower for the rest.

• Retailers sometimes offer "0% interest" loans on consumer items where they just increase the retail price to account for a certain interest rate. You can sometimes (not always) negotiate a better price if you pay upfront with cash (not a credit card, since they change the retailer 2-3%) on large items.

• "Payday loans" charge interest upfront - even if you pay back the loan early, you still owe the full amount of interest (typically classified as a "fee" to avoid usury laws).

Answer 3

I think you have amortising and compounding confused. Amortisation means that the total amount still owing falls with each payment - you could have an amortising loan with 0% interest.

Taking your example a $500k loan with 0% interest could amortise over 10 annual payments of $50k, for example, meaning that the total loan repayment would be $500k versus $600k on the same $500k loan. The borrower will also own an extra 10% of the property each of those 10 years. This means that my amortising loan is more equitable to borrowers than your 10% one time fee!