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If the title sounds ridiculous, please hear me out before downvoting.


Let's start simple. You have too much money on your hands and want to start a loan business.

If you neither want to gain nor lose the intrinsic value of your money through giving someone a loan, you would give them an interest rate equal to that of inflation. Let's say the inflation rate is at 2%/year.

If you're trying to run a business, you need to actually make money so you can pay the bills for your business. The solution is to give out loans with a higher interest rate, like an interest rate of 3%/year.

If you're trying to run a business, you need to also account for the risk that the principal will never be paid back, so maybe you bump that interest rate up to 4%.

So far so good? Let's sum it up. Here's the idea:

  1. You loan $X to the debtor.

  2. Debtor must legally pay you back 4% (breakdown above) of the remaining principal per year.

  3. If debtor is allowed to pay less than the required 4% per year, then he's effectively borrowing more money that will accrue more interest, so that's equivalently just adding to his principal.

  4. If the debtor pays more than the 4% per year, the difference subtracts from the principal similarly.

  5. The debt is fully paid whenever the principal reaches zero. Could be now, could be in 100 years.
    And if you want, you can set a legal deadline. But the mere deadline in the contract doesn't affect how much interest is paid—the interest is only affected by how much money is borrowed and how long has passed.

So my question is the following:

Why isn't the above the business model of a loan?

i.e.: Why do I need to deal with apparent nonsense like the following?

  1. "Is it an 30-year loan or a 10-year loan?"
    What does it even mean and what difference in the world does it make?
    It doesn't even enter the picture I just showed above!
    You should be able to pay back whenever; what's the point of an arbitrary timeline?

  2. "If you pay extra, do you want the extra to go toward the interest or toward the principal?"
    Again—what sense does this question even make? Like I showed above, you just owe whatever you owe so far—you can call it the interest or the principal or the frog.
    It seems like the interest merely needs to be a function of how much you have borrowed and how long you have kept the money so far.
    Why add more complications so that "should I call this principal or interest" actually makes a difference? Why's the point (incentive) for this?

Note:

To be explicitly clear, I am NOT asking what differences the extra parameters make in the current business models! I understand the mathematics just fine. I am asking why the business models are so complicated in the first place, when it seems (to me) that they only cause confusion and don't have any fundamental need to be that way, when something simple like the above seems just fine. Is there a legal reason? Is there a risk-management or other game-theoretic reason? Is it another practical reason I'm not considering? etc.

  • If I understand correctly, your scheme would give the borrower the possibility to turn any loan into a (not-even-full)-interest-only, ever increasing loan, at least until the deadline or the debtor's death, a huge risk that ought to be reflected in the interest rate, if it can be handle at all. Anybody willing to commit to a more specific schedule would prefer a regular loan. 10 years vs. 30 years matters and “whenever” is not good enough, if nothing else because people eventually die. – Relaxed Aug 9 '17 at 10:02
  • Which country are you talking about? – Aganju Aug 9 '17 at 10:22
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    Many loans are collateralized, and the lender will expect that the collateral will provide a reasonable chance of insuring against default. A lender will not want a loan to be extend past the useful life of the collateral (or decrease in principle more slowly than the decrease in value of the asset). – user4556274 Aug 9 '17 at 12:27
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    Because to me, and I think to most people, the N-year loan is simple, while yours is complicated. Also, given human nature, a certain (and probably significant) fraction of borrowers will stop repaying their loans in the smallest financial pinch, leading to a lack of predictable cash flow. – jamesqf Aug 9 '17 at 17:27
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    @quid: If you want my comment as an answer, feel free to make it into one, on the condition that you deal with the (multiple expletives deleted) individuals who inevitably complain about insufficient references &c. – jamesqf Aug 10 '17 at 4:49
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Why isn't the above the business model of a loan?

It is the model of some types of loans. It's called a "Line of credit" (LOC). I have two them, one for my business, and one for me personally.

(Why does this question exist:) Is it an 30-year loan or a 10-year loan?

As you mentioned, the concept of term doesn't exist for these types of loans. As long as I pay the interest and don't go over the max of my credit limit, I could keep the money indefinitely. Due to this, lines of credit almost always have a variable interest rate. (In the US they are tied to the Prime rate.)

(Why does this question exist:) If you pay extra, do you want the extra to go toward the interest or toward the principal?

Again, this concept also doesn't exist with a LOC. There is a minimum payment that you must make each month, but there is nothing that prevents you from making the minimum payment and then immediately taking the exact payment you made back out again. Of course this increases the total you owe, and eventually you would hit your maximum credit limit and would no longer be able to take the full payment back out. Years ago I maxed out my business line and didn't have enough money to make the payment so my bank was nice enough to raise my limit for me (so I could take enough out to make the payment), but if I did that multiple times I'm sure they would have eventually said no. Fortunately my clients finally paid me and I paid off the line, but I still keep the LOC today even though I rarely use it.

By the way, beyond traditional LOCs, they also exist in other forms, both secured and unsecured. A common secured product in the US is a 2nd lien holder to a home (the first being the mortgage), called a HELOC (Home Equity Line Of Credit). Many banks also offer unsecured LOCs on a checking account which they sometimes call "overdraft protection".

Update: based on a comment to this answer, I now realize that the full question now becomes something similar to:

Given that the Line of Credit loan model exists, why aren't all loans like this?

or, refining it further:

What advantages do other loan types have over the Line of Credit model, specifically finite term loans?

A main advantage of a term loan over a line of credit is that the bank knows when they will get the money back. If every loan a bank made was a LOC product, and no one ever paid it back, then they'd eventually run out of money. That's obviously an oversimplification but the principle (pun intended) holds. To prevent this the bank would have to call due the loan, and doing this usually leaves customers angry. Years ago I had a business LOC with a bank that discontinued their business LOC product, and called every customer's loan due. I had a balance and they offered to convert it to a 5 year term loan, which I did, but I was so mad at them that I switched banks and paid off the term loan shortly after.

Another advantage of a term loan is it forces the customer to be a little more responsible. Lines of credit can be dangerous for those that misuse it because if the amount owed is driven up due to bad behavior, there is nothing to force the bad behavior to stop. A perfect example of this can be found with governments. Some governments borrow money until their line of credit is used up, and then they just keep increasing their credit limit. There is no incentive for the officials in charge of the government to stop doing this because it isn't even their money. If those lines of credits were converted to term loans, the government would be forced to increase revenue and/or decrease expenses, which is the only way to get out of debt.

Some other advantages of term loans over a LOC:

  • Since the repayment period is fixed, it's easier to have a fixed interest rate. Most LOC products are a variable rate.
  • It's easier for banks to sell a term loan to another bank, because budgeting is easier with term loans.
  • Due to the lower risk to banks, the interest rates on term loans are typically lower.
  • +1 though it doesn't really get close to fully answering the question. (Like "why aren't loans like this?" isn't fully answered by "some loans are like this"; I'm hoping for a reason for the others.) – Mehrdad Aug 10 '17 at 5:21
  • @Mehrdad - I have updated my answer based on your comment. – TTT Aug 10 '17 at 12:49
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    Fantastic update, thank you! Lots of great answers on this page but this one finally nailed it I think. The part about calling the loan due was especially intriguing since I didn't realize that was a possibility in reality. – Mehrdad Aug 10 '17 at 21:14
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This model would work fine under a couple of assumptions: that market interest rates never change, and that the borrower will surely make all the payments as agreed. But neither of those assumptions are realistic.

Interest rate risk

Suppose Alice loans $1,000,000 to Bob at 4% under the terms you describe. Bob chooses to make interest-only payments of $40,000 per year. Some time later, prevailing interest rates go up to 10%. Now Alice would really like Bob to repay the entire principal as quickly as possible, because that money could be earning her $100,000 per year instead of only $40,000, but under the contract she has no way to force Bob to do so. And Bob has no incentive to repay any of the principal, because he can earn more interest on it than he has to pay to Alice. So Alice is not going to be very happy about this.

You might say, but at least Alice is only losing "potential" money; she's still turning a profit of $10,000 per year, since her bank only charges her 3% interest. Ah, but you're assuming that Alice can get a bank loan with a rate of 3% fixed forever. The bank doesn't want to make such a loan either, for exactly the same reasons.

So in practice, any loan like this would be expected to have a variable interest rate.

There's a flip side, too. Suppose instead that market rates drop to 1%. Now Alice would like Bob to repay the principal as slowly as possible, because she's earning 4% on that money, which is better than any other options available to her. But Bob now has every incentive to repay it as fast as he can - or even to refinance by taking out another loan at, say, 2%, and using the proceeds to repay the entire principal to Alice. (This risk still applies with most traditional loans, since the borrower usually always has the right to pay early, but some loans include a "prepayment penalty" in such cases to help compensate the lender.)

Thus, when Bob has all the power to decide when to pay, Alice is sure to lose no matter which way interest rates move. A loan with a fixed term helps insulate Alice against this risk. She may be able to make a guess about the likelihood of interest rates going up to 10% in the next 15 or 30 years, and increase Bob's fixed rate to account for this; that's much easier than trying to account for the possibility of interest rates going up to 10% ever. (And if she does have to try to account for this, she's probably going to have to set the interest rate extremely high; so Bob might accept a fixed term of repayment in exchange for a more reasonable rate.)

Default risk

Even if we suppose that Alice has done the best possible credit check and that Bob is a perfectly trustworthy fellow who would never dream of defaulting on his loan, catastrophes do happen. Maybe Bob is robbed of all his money by an evil accountant, or has a mid-life crisis and spends it all on opera tickets. Whatever, Bob is now bankrupt and Alice is never going to get her principal back, nor any further interest payments either. Even if the loan is secured by some collateral, there's still a risk since the collateral might lose value.

Alice has some chance of estimating the risk of this happening in the next 15 or 30 years, and can set the interest rate to compensate for it. But it is harder for her to estimate the risk of this happening ever, and if she tries, she'll have to set the rate so high that Bob might prefer a fixed term and a lower rate.

(There's a side issue as to what happens if Bob dies with the loan still outstanding. If it's an unsecured loan, typically Alice can try to collect the principal from Bob's estate, but if there isn't enough, too bad for Alice; she can't force Bob's heirs to continue making payments. If it's a secured loan, Alice may be able to have Bob's heirs continue paying or else she seizes the collateral; but she still has the risk of the collateral losing value.)

  • You could index the interest rate in my scheme with inflation... that wasn't fundamental to my question at all. But +1, it's a reasonable answer. – Mehrdad Aug 10 '17 at 2:52
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You should be able to pay back whenever; what's the point of an arbitrary timeline?

Cash flow is the life blood of any business. When banks loan money, they are expecting a steady cash flow back. If you just pay back "whenever" - the bank has no idea what they'll be getting back month-to-month. When they can set the terms of the loan (length, rate, payment amount), they know how much cash flow they expect to get.

What does [the term of the loan] even mean and what difference in the world does it make?

In addition to the predictable cash flow needs above, setting a term for the loan determines how long their money will be tied up in the loan. The longer a bank has money tied up in a loan, the more risk there is that the borrower will default, so the bank will require a greater return (interest rate) for that extra risk.

What you have described is effectively a revolving line of credit. The bank let you borrow money arbitrarily, charges you a certain rate of interest, and you can pay them back at your schedule. If you pay all of the interest for that month, everything else goes to principal. If you don't pay all of the interest, that interest is added to the balance and gets interest compounded on top of it.

Both are perfectly viable business models, and bank employ them both, but they meed different needs for the bank. Fixed-term loans help stabilize cash flow, and lines of credit provide convenience for customers.

  • So to sum it up, you're saying it's so that they can give consumers a lower interest rate (less risk)? +1 assuming I understood it correctly :) – Mehrdad Aug 10 '17 at 5:19
  • ... to be competetive with other banks, yes. But there's more to it that just that. Nate's answer is much more comprehensive than mine. – D Stanley Aug 10 '17 at 13:57
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Basically, what you describe exists in many countries - not in the USA though. In Europe, people have checking accounts with allowed overdraft, typically three month net salaries. You can just this money any day as you like, and pay it back - completely or partially - any day as you like. Interest is calculated for each day on the amount used that day; and the collateral is 'future income', predicted / expected from previous income.

In the USA, credit cards have taken its place, with stricter different rules and limitations.

In addition, many of the extra rules in loans were invented to take advantage of the ignorance or situation of the borrower to make even more money. For example, applying extra payments to future due payments instead of to the principal makes that principal produce more interest while the extra payments just sit around.

  • Oh I see. So to be clear, you're saying in those cases there's no notion of "do you want to apply this extra payment toward the principal or toward the interest", right? (i.e. in this scheme the question should not even make sense -- that is not the same thing as saying one is already chosen and they deny you the the ability to choose the other. Just want to make sure we're on the same page.) – Mehrdad Aug 9 '17 at 10:43
  • Right. There is simply a running total that bears daily interest.. – Aganju Aug 9 '17 at 10:56
  • Awesome, thanks. +1 So what's the reason this isn't done for actual loans in the US (and/or elsewhere)? ("Actual" meaning things people actually call "loans", like car loans, mortgages, etc... not credit card purchases or cell phone payments or whatever.) – Mehrdad Aug 9 '17 at 11:01
  • Also, I think I might've just realized how to reconcile the two schemes. So the reason they put your extra payments toward your future payments is (probably/presumably) so you don't get hit with a non-payment penalty the next month you don't pay and then sue them claiming that you'd already paid. But if you take my scheme and add on a contract term that requires a minimum monthly payment like I had described, then you should get exactly what you would get in the current scheme by applying your payments toward the principal. Would you mind verifying if this is correct, or is there a difference? – Mehrdad Aug 9 '17 at 11:16
  • Though the logical thing to do in that case is to just wait and calculate it whichever way is most beneficial to you at the end depending on whether you pay anything the next month, rather than making a decision up-front... hm. – Mehrdad Aug 9 '17 at 11:24
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Your first question has been answered quite well already. To answer your second question:

"If you pay extra, do you want the extra to go toward the interest or toward the principal?"

This gives the consumer some flexibility to decide how additional payments are applied. It might seem like a no-brainer to always apply extra payments towards principal - that way, the interest amounts on future payments will be lower and (if you're billed a fixed amount each month) more of each regular payment will then be applied to principal, shortening the term of the loan.

However, while it would mean spending more over the life of the loan, there are certain advantages to applying extra payments towards interest. The main advantage is that it pays your account ahead and means you don't have to make another payment as soon. You could use this strategy to give yourself a buffer of several months, so that if you should ever run into financial hardship you can stop making mortgage payments for a while without the risk of foreclosure.

† Note, in most cases it's more likely that you are simply paying more without specifying to the lender that it should be used as principal curtailment. I haven't seen cases where you can explicitly ask the extra to be "applied toward interest". In this situation the funds would be held until you've provided enough to cover one or more monthly payments in full, at which point your "next payment due" date will simply be extended.

Another advantage is that the funds that are being held (not due yet, not allocated toward any specific payment, maybe held in escrow) may be refundable to you, upon request. This would depend on the lender's policy. Some will permit refunds of credit balances that go beyond what is necessary to cover the current month's bill.

Whether you apply extra payments towards principal or not, it makes little difference to the bank. Any additional payments received increase their immediate cash flow. The cash can be reinvested immediately by them into whatever they are currently focusing on.

  • +1 for the second-to-last paragraph. I completely didn't realize that. – Mehrdad Aug 10 '17 at 5:23
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There are other good answers to the general point that the essence of what you're describing exists already, but I'd like to point out a separate flaw in your logic:

Why add more complications so that "should I call this principal or interest" actually makes a difference? Why's the point (incentive) for this?

The incentive is that using excess payments to credit payments due in the future rather than applying it to outstanding principal is more lucrative for the lender. Since it's more lucrative and there's no law against it most (all) lenders use it as the default setting.

  • Haha, I would hope that there's at least some surface explanation for it that isn't greed, even if it's not terribly convincing. Like in this case I suspect it's so that you don't sue them for not applying it to your next payment if you suddenly decide not to make the next payment ("well you already had the money earlier..."). – Mehrdad Aug 10 '17 at 5:22
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    There isn't; though I wouldn't call this greed. It can't possibly be surprising to you (or anyone else) that the bank prefers loan terms (that aren't illegal in the US) that increases its revenue. Loan terms which are spelled out in the contract you signed. Greed would be what BofA was doing when it rearranged the order of transactions at the end of the day to process large transactions first causing multiple overdraft charges on the smaller (potentially earlier) transactions. Which was perfectly legal until the financial reforms that passed in '09 or '10. – quid Aug 10 '17 at 5:59
  • Haha I guess it's in the eye of the beholder. If there's one clearly obvious way to process overpayments in favor of the consumer (i.e. what they would expect you to do) but you deliberately choose the other one to eek out a few more dollars, that sounds awfully like greed to me, unless there's another strong explanation (and I'm not sure whether there's a strong one in this case). Great note about that one though, I didn't know financial reforms made that kind of processing illegal! Would you have a link to more reading about this (or search terms I could use to find more)? – Mehrdad Aug 10 '17 at 6:11
  • It looks like I misspoke, BofA didn't change the policy because of a regulation but because of increased regulatory interest. Basically BofA changed the policy before congress sat down to pass a law forcing their hand. consumerist.com/2013/10/22/… – quid Aug 10 '17 at 6:21
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I'm going to give a simpler answer than some of the others, although somewhat more limited: the complicated loan parameters you describe benefit the lender. I'll focus on this part of your question:

You should be able to pay back whenever; what's the point of an arbitrary timeline?

Here "you" refers to the borrower. Sure, yes, it would be great for the borrower to be able to do whatever they want whenever they want, increasing or decreasing the loan balance by paying or not paying arbitrary amounts at their whim. But it doesn't benefit the lender to let the borrower do this. Adding various kinds of restrictions and extra conditions to the loan reduces the lender's uncertainty about when they'll be receiving money, and also gives them a greater range of legal recourse to get it sooner (since they can pursue the borrower right away if they violate any of the conditions, rather than having the wait until they die without having paid their debt).

Then you say:

And if you want, you can set a legal deadline. But the mere deadline in the contract doesn't affect how much interest is paid—the interest is only affected by how much money is borrowed and how long has passed.

I think in many cases that is in fact how it works, or at least it is more how it works than you seem to think. For instance, you can take out a 30-year loan but pay it off in less than 30 years, and the amount you pay will be less if you pay it off sooner. However, in some cases the lender will charge you a penalty for doing so. The reason is the same as above: if you pay off the loan sooner, you are paying less interest, which is worse for the lender. Again, it would be nice for the borrower if they could just pay it off sooner with no penalty, but the lender has no reason to let them do so.

I think there are in fact other explanations for these more complicated loan terms that do benefit the borrower. For instance, an amortization schedule with clearly defined monthly payments and proportions going to interest and principal also reduces the borrower's uncertainty, and makes them less likely to do risky things like skip lots of payments intending to make it up later. It gives them a clear number to budget from. But even aside from all that, I think the clearest answer to your question is what I said above: in general, it benefits the lender to attach conditions and parameters to loans in order to have many opportunities to penalize the borrower for making it hard for the lender to predict their cash flow.

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