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This discussion allows us to consider financial decisions of individuals, corporations, and commercial and non-commercial entities alongside pricing of financial products valued using time value of money concepts introduced in this module. We learned in Module 1 that all cash flows are inherently risky. In this module, we notice that financial products and services are valued based on the level and timing of cash flows they produce. Riskiness of cash flows affects the probability that payments will be received within planned time periods. Riskiness of cash flows affects the value of a set of cash flows through its effect on the timing of payment. This uncertainty can result in additional fees or other payment penalties or incentives. In this discussion, we consider the effect of uncertainty regarding timing of payment on products and services priced using the time value of money. We conclude by considering how this affects individuals using these products, lenders and investors, and the public more generally.
Module 4:
Case
Background Transcript
One application of time value of money is the commercial provision of credit to individuals, firms, and commercial and non-profit entities, including municipalities and governments. Payment by Installment (personal or consumer use of credit) is often traced back to between World War I and World War II, when mass production of high-value goods, such as cars and washers and driers, made credit purchases common. Consumer debt has continued to increase (with only minor periods of decline) during the interwar period. According to research, consumers have increasingly used debt to level or smooth consumption between periods of high and low income and to invest in homes and education. These activities require individuals to weigh current and future payments against future benefits in the same way that firms weigh financing costs of debt products against the expected value of cash flows resulting from them.
Unlike firms, which normally employ trained individuals to make financial decisions, individuals may not have the financial tools to think effectively about financial decisions. Consumers with very poor credit may be particularly unprepared to make good financial decisions. An example of lending to consumers with poor credit is Payday Lending, or short-term borrowing of small sums where a lender offers high-interest credit based on a borrower’s income and credit profile. Many states regulate this practice; some states set an interest rate cap. In 2008-2009, a dramatic decline in financial and economic activity took place that has come to be called the “Great Recession of 2008-2009.” As a result of the Great Recession, policymakers realized that credit use can have broad systemic consequences to the flow of funds that power financial activity. A Consumer Financial Protection Bureau (CFPB) was established following the Great Recession. The role of the CFPB is to educate and monitor consumers’ use of credit. The CFPB also regulates financial goods and services offered to consumers commercially. The CFPB regulates Pay Day Loans, for instance. The CFPB notes that a typical two-week payday loan with a $15 per $100 fee equates to an annual percentage rate (APR) of almost 400%, while APRs on credit cards can range from about 12% to 30%. Payday Loans typically require a post-dated check or permission to take repayment automatically from a debtor’s bank account for the full amount owed on a due date. The date of the post-dated check is usually required to correspond to receipt of a paycheck or social security payment.
Firms and commercial and non-profit entities, including municipalities and governments, may make accept high-interest loans for very different reasons. In this module’s required readings (see section 4.5 and p. 128 of Finance: Applications and Theory), we notice that the timing of payments affects the cost of debt products, including credit cards, short term loans, and related products. Regardless of their reasons for borrowing, all borrowers with evidence of poor historical repayment habits or indications of inability or unwillingness to repay debts are charged high interest rates and often encounter additional fees. A credit score is a tool that lenders use to set interest rates offered to consumers. A credit score offers lenders an index describing a consumer’s historical repayment habits. Borrowers with very poor historic payment activity are considered sub-prime or even “deep sub-prime” (defined as having credit scores below 580).
Nationally, lending to deep sub-prime borrowers has risen since the Great Recession of 2008-2009. This is so even while the Great Recession of 2008-2009 exposed the riskiness of lending to sub-prime borrowers and contributed to a broad collapse in credit markets. In 2008-2009, it became apparent that many lenders held risky debt products, making financial institutions unwilling to lend to one another. This perception of wide-spread risk cut the flow of credit to consumers, firms, and commercial and non-profit entities. Consumer borrowing in general has risen steadily since the 1970s. Borrowing—and credit generally—supports consumer spending. A consumer might need gas in their car on Monday when they are not paid until Friday, for instance. Consumers might need to use a credit card to put gas in their cars to get to work. They may need to purchase furniture and appliances on credit, or they may need to promise future income to repay a home mortgage or car loan. These credit “instruments” support spending when current income is insufficient to do so.
Consumers, firms, and commercial and non-profit entities, including municipalities and governments, may all borrow, even when financing costs are very high. According to TransUnion (a credit-reporting agency), sub-prime lending (including lending to deep sub-prime borrowers) constitutes 11% of all non-secured lending, with room for growth. Subprime fees and interest exceeded 40% of borrowers’ year-end balances, according to the Consumer Financial Protection Bureau. Non-secured lending is risky because it is not backed by collateral or an asset that may be sold to compensate a lender if a borrower fails to repay in a timely fashion. In the Great Recession of 2008-2009, even asset-backed lending became risky when asset prices fell. In 2008 and 2009, risky assets – even those backed by collateral – were difficult to sell. This difficulty damaged the liquidity of financial institutions and their ability to keep funds flowing out to consumers and others, even those with very good credit.
Case
Jacquelyn has selected a Payday Lender with fees above those offered to sub-prime borrowers approved for credit cards or other forms of unsecured lending. Once a month Jacquelyn visits a lender willing to offer her an advance on her paycheck. Jacqulyn insists this allows her to meet obligations, including rent and cost of prescriptions, that she would not be able to meet otherwise. Interest rates are compounded daily at a set percentage and, measured annually, may reach above 1,500%. Jacquelyn does not live in a state that caps interest rates. Jacquelyn has had numerous adverse credit events in the past, however her current lender’s fees and other conditions offer enough of a guarantee to allow this lender to extend necessary credit. Because of the high financing costs paid currently, in part, Jacquelyn’s credit is unlikely to improve in the short term. She has been unable to stay current on student loan repayments. Her income has not grown as expected and has been unstable. She has taken temporary positions to supplement her income and is still looking for work in her field.
Case Questions
Initial Post
Based upon this module’s required reading and the background information provided here, form an initial post covering the following four issues:
Section 1
- Based upon this module’s required reading, explain briefly how interest rates for borrowers, including high-interest borrowers like Jacquelyn, are determined. You might consider observations on p. 128 of our textbook.
Section 2
- Identify and analyze one benefit sub-prime borrowers like Jacquelyn or society receives from high-interest borrowing.
Section 3
- Recognizing that some states set interest rate maximums, identify and analyze one cost or negative effect that borrowers, including sub-prime borrowers like Jacquelyn, or society suffers as a result of high-interest borrowing.
Section 4
- Why might firms or commercial or non-profit entities, including municipalities or governments conceivably turn to high-interest borrowing?
Section 5
- Comment on limitations of lending to individuals and other entities with poor credit that you learned about in reflecting on sections 1-4.
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