A commenter last week on Trent’s article about whether or not it’s ethical to walk out on a mortgage said something that I feel needs to be addressed. He wrote:
I must say that at first when I read this title I thought that it could be pretty cool to just walk away from a mortgage. I mean aren’t banks unethical taking all your money away from you with home loans and especially credit card debt.
There is a grain of truth in this. Some banks and banking officers have been quite willing to use their position as the “experts” to push financially-illiterate people towards loans and the like which they couldn’t afford. But what does this commenter mean “taking all your money away from you with home loans”?
I assume that he means charging interest, which is the only way they take your money (after all, if you’re just paying back the price of the house, that’s the same thing you’d be paying the seller if you bought the house with cash). But the bank isn’t ripping you off by charging you interest. They’re not being unethical unless they try to trick you about it or flat-out lie to you. Why?
Interest Is the Cost of Giving You Money
Why does a person take out a mortgage? Because she doesn’t have the money up-front to pay for the house. But by giving her that money, banks take on an opportunity cost (as well as a risk).
Suppose you’re a bank and you have $300,000. You could invest that money in the stock market. There, it might get anything from 2% to 15%, depending on how good the year is and how well you invest it. What motivates you to forgo years of earning interest off that money?
Guaranteed (ish) money. There’s no point in giving out a mortgage for charity unless you’re a charity. Giving out a mortgage to a person who will repay the loan with interest is a nice, solid way to make money off your money. You don’t have to worry as much about the variation in the market (as long as unemployment doesn’t skyrocket).
Of course, the person might walk away or miss payments. So there’s a risk involved, which accounts for a few more percentage points on some people’s mortgages. How many depends on credit history and how the bank views their source of income.
But banks are in no way obligated to lend you money. They certainly wouldn’t do so if they didn’t make any money off it. Where do you think the interest on your savings account comes from? The bank’s various investments, including mortgages.
Interest Is the REASON You Get the Money
So interest is the reason that you got that home loan in the first place. If it didn’t exist, banks wouldn’t be willing to give mortgages. People would probably not be willing to buy stocks either. Interest is the incentive that you give someone so they’ll give you what you want. (Micah chimes in: “Why would you want to trade my $100 for your $100? But look, my $100 comes with 5 extra dollars!)
It’s the same with a cup of coffee. Starbucks requires that you buy the coffee you drink. You get the coffee because you paid for it. They don’t sell at cost, either. They’re a business and they have coffee. They’re willing to give it to you, but only if you pay. Banks do the same with their money.
If you don’t want to pay interest, you must simply save up for the item yourself. Or grow/grind/brew your own coffee.
You Don’t NEED to Pay Interest
But you may consider the alternatives less-than-ideal. You can choose to rent homes throughout your life, or until you save up enough to buy a house outright.
You can constantly lease (rent) cars, but that’s generally a worse option than financing them. I know this may sound like heresy to some, but if you actually need a different car and you don’t have the money, you may have to finance it. That’s not an excuse to buy the newest, fanciest car even though money’s tight (unless that’s how you want to live…) but financing is a viable option.
Or you take out a student loan because you don’t have quite enough money to pay for all your college now. You could also put off college, but you may not consider that the best choice. That doesn’t mean you shouldn’t look for scholarships, grants, and earn money. But in the end it’s a choice.
In some cases it’s something worse than “less-than-ideal,” like in cases where you can’t pay the rent without a loan. But if you can’t pay the rent without a loan, you have more to worry about than interest. In most cases, it’s less urgent and more a matter of choice.
However You May See It as Worthwhile
Like buying anything, you have to decide whether buying this money is a smart shopping decision. Is what you’re going for worthwhile? Micah decided that a PhD now was worthwhile. (I decided that he was very worthwhile!) But we’ve decided that carrying a balance on a credit card is not worthwhile.
He decided that financing a car was worthwhile. Whether or not it was at the time, next time around we hope to pay as much as we can in cash (and limit our car-shopping to sensible ones we can afford).
You have to make the choice whether the item is worth saving for or if it’s better to pay more for the convenience of having it now. A college education is valuable at any time, but many people want it before they go into the work force. They believe it’ll pay off in higher salaries. If you’re already going to pay rent, you may see a home as worth financing because you plan to live in it for many years to come.
So Is Charging Interest Unethical?
On the part of the banks, charging interest just makes sense. It plays to the rules of our society—you can’t force someone to give you something, you have to pay them for it somehow. In this case, you’re buying money. And you’re buying it so that you can have more time. So you don’t have to wait until you’re 40 to buy your first house or so you can have a new book now instead of next week.
The only way the bank is willing to sell you their money is if you make up for the other opportunities they could have had to earn money with it.
If the bank does attempt to defraud you, deceive you about your payments, etc, then that is certainly unethical behavior. Some actions taken by credit card companies are unethical. Others get into very gray areas where you’re not sure they were trying to be unethical, but it still feels like there’s something wrong.
And sometimes the bank may not be defrauding you, but you didn’t fully understand the terms. Like using a balance transfer card to buy things that will accrue interest until you’ve paid off the transfer. Which is why it’s so important to read the fine print.
Do I believe that it’s unethical for a bank to charge me interest? No, I don’t think so at all.
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LoL and smiling @ your comment about deciding Micah was worthwhile!
I certainly don’t think it’s unethical for banks to charge interest. They’re providing a service for their customers and like with any other business, there’s a fee (the interest) for using that service.
Of course, there’s a whole ‘nother host of issues with predatory lending and trying to push people to “buy” financial products they’re not sure about, but that’s a different issue entirely.
Indeed. There is certainly unethical behavior by many brokers and bankers who act in their own best interests instead of their clients’. But interest isn’t part of that.
Charging interest in itself is not unethical. Charging usurious rates is.
So is luring unsophisticated and unknowing borrowers into loans they will be unable to pay–and don’t understand they won’t be able to pay–so that you can turn them into cash cows, their welfare be da–ed. As you point out, that’s a different issue from interest. However, it’s probably related, because the lack of usury laws in this country allows lenders to cook up instruments whose rates will steadily rise into the unaffordable range for their borrowers.
🙂 When Micah finishes the Ph.D. (very worthwhile!), you’ll prob’ly be able to buy a new car with a smaller loan and pay it off quickly. Then the next car: cash on the barrelhead!
I agree 100%, there’s nothing unethical about charging interest when lending out money.
If you disagree, please get in touch with me urgently. I’d like to take a loan from you.
Well put. You use the term buy money. It might make more sense to say you are renting money. Because you need to give the money back and pay a fee for the time you have it.
Funny about Money mentioned usury. That is a difficult subject. Bankers like everybody else prefer to make a good return on their money. If they can do it by loaning it they will but if the stock market offers a higher return, they will do that. There are a lot of costs that are recovered in the interest besides earning money on the money. On purchases you usually get the first 30 days without interest (if you are not carrying a balance). Some of that is covered by the fee the merchant pays. But that is only about 2-3% of the purchase. When you make a purchase, the merchant gets the money rather soon but you have a month to pay it off at no cost. There is the cost of the entire computer network that authorizes your charges. There is customer service. There is billing and crediting your payments. There is the 4-6% of the money spent on credit cards that is never paid back. Not only is that a loss but they didn’t make interest on that either. All of these things and more add up to the interest rate you pay.
A few years ago, some people planned on bankruptcy to clear their debt. This was reduced by changing the bankruptcy laws. Because of the abuse by some, there are people with real problems now who do get the protection bankruptcy use to offer. Legal solutions to perceived problems can have wider ramifications than expected. Usury laws could have that affect. You may find if there is a limit on the interest rate that is not governed by financial reality, there won’t be any loans to buy houses with or finance your education. As Mrs. Micah said, there is no law that anyone has to lend you money.
As with any company, banks charge what the market will bear. If that is not enough they will put their money elsewhere.
Do banks try to trick their customers into paying more fees and interest than is reasonable. Definitely. That is why blogs like this are valuable. I am appalled that our public schools in general don’t offer money literacy courses. Today’s young people are very computer literate. They need to scan the net for information that lets them understand the terms and agreements of their credit cards, car loans, house loans. They aren’t that complicated. But to write the terms in a form that a court of law will enforce makes it difficult to understand.
One general piece of advice. If you think you have a way to beat the banks in making money, watch out. There is probably a pit under the leaves that you will fall into. Most people in the mortgage crises probably didn’t think things through. But I’ve known of some who thought they were beating the banks. But they got beat. The banks thought they were on to a great thing but the bubble burst for them too.
I think this topic requires a little more of a kick in the pants. Of course they can charge you interest! They can charge you whatever they want too. They can charge you $10 to take money out of an ATM that doesn’t belong to your network, they can charge you $100 if you overdraw from your account. Why not? You’re the one making the mistake and they’re the ones providing a service for you. Don’t like to pay interest/fees? Don’t break “the rules.” Don’t take out a loan. People think loans are their god-given right, snap out of it people!
@WC, another excellent point. I’ve seen some people become very upset because the bank shut down their HELOC. Since an HELOC is essentially a pending loan (unless you’ve used it), they have every right to say that they don’t like your collateral as much or that they’re loaning to fewer people. Just because you have a house doesn’t mean someone has to give you another mortgage.
Anyone that thinks that banks shouldn’t charge interest must have a hard time buying anything, as everything we buy, from coffee (like MM said) to a car to a house is “marked up” to make a profit, just like a loan is. And as someone above said, if you believe they should not charge it, I would like to borrow a large sum of money from you and pay you back the exact same amount, slowly, over the next 30 years. Deal?
Shariah law forbids interest (usury, but it is less strict than western definitions of that term)… but that applies to both earning and paying. Interesting because early Islamic societies are some of the earliest examples of free market capitalism.
Don’t get me started about banks. Individuals should be able to charge interest no problems, but banks aught to be monitored constantly to prevent them from abusing the public in every way possible. Too bad it’s the opposite: Individuals don’t have any power to charge interest (the bank dictates the pitance to be given) while the bank charges whatever obscene amounts they feel like.
The money does not belong to the bank, it’s your own money being lent back to you (and mine, and other people’s). Or it’s the bank lending to unworthy customers at high rates and then selling the bad loan to unsuspecting investors.
The Islamic system is pretty neat because they still have banks and something like loans, but the banks are more like partners. As deepali mentioned, no interest can be charged under Shariah, so the banks lend money and become like principals in the business, or part owners of the house.
Anyway, I agree in the concept of interest and time value of money because it should direct money towards the most efficient use. However, you have to agree that people feel quite abused when they are sucked into buying homes at huge prices, that they can’t afford, by banks who have the power to totally destroy your life if you can’t quite work hard enough to pay the schedule they’ve given you. Of course buyers have choices, but not everyone is an expert. They go to bankers and realtors because bankers and realtors are supposed to be experts and you should be able to trust them.
@Customers Revenge. I see what you’re saying, but…
While the money is “your own” (or a lot of people’s) it’s money that you gave the bank to make money with. If you don’t want the bank to be making money off you or other people with your money, then keep everything invested in other companies or in a safety deposit box (or a sock, but a safety deposit box is safer for large amounts).
As for the other, I think there’s more involved in people making bad decisions than bankers forcing them into it. Bankers may not try to stop them and encourage them, but there are more societal forces at play in the situation. Emphasis on status & lifestyle, comfort with debt, jealousy, competition, and poor financial education certainly can’t all be laid at the feet of banks.
BTW, got a link to this in today’s round-up post at FaM. Love it! 🙂
Some of the comments on The Simple Dollar post sent me into a rabid rant-fest. Thanks for being a well-spoken voice of reason.
I agree — I don’t understand how someone can expect to be loaned $400,000 over 15 or 30 years and not expect to pay for that convenience! While Islamic law doesn’t permit interest (we just wrote about it here http://www.creditcards.com/credit-card-news/shariah-compliant-credit-cards-1273.php), that’s really the only exception I could think of. What the banks are doing isn’t immorial — that’s just how they make profit, and we choose to use those services. Like you said, if you don’t want to mess with it, just save.
This article is based on the assumption that banks actually have the cash reserves of everything they lend. The system is fractional reserve. So banks are making profits from interest charges on lending nothing but credit that is electronically created at the time a loan is made. They are not risking any actual assets of their own. So why should they profit from this?
Exactly, Mason. The money that the bank is lending out is not only not theirs, it doesn’t even exist. It’s double-entry bookkeeping. The bulk of the money loaned out becomes both a liability for the debtor and an asset for the bank at the same time. That is how the fractional reserve system works. Banks loan out at least 10 times as much as they have in reserves (deposits). The government has allowed this behaviour to become a normal function of our economic system.
I find it ironic that this article and the majority of the comments were written just prior to the massive banking bailout that took place after the collapse of Lehman Brothers. To say that the loaning money into existence so that some family can buy a house and live a decent life is a ‘risk’ for a bank and therefore makes it somehow OK to charge double or more for the amount of the house over an amortization period of 30 years is a distortion of morals to a degree that I cannot begin to fathom. This entire article is completely ignorant of the history of debt and fiat currency, and entirely wrong in its assumptions.
It is ignorance of the banking system–and the money system in general–that lead to these ridiculous opinions that charging interest is somehow OK. When central banks, which are usually owned by commercial banks, print their fiat currency and loan it to governments at interest, where is the money supposed to come from to pay this interest back if it does not yet exist? This is the start of the massive interest (usury) cycle, that is passed down the line to the lowest, poorest people who are pressured to work harder, more efficiently and so on, just to keep up with their interest payments. Economic growth–the ecological effects should be abundantly clear–is a necessary part of a pathological society that accepts charging interest (usury) as a normal practice. Usury, as it was previously called, meant earning money without doing any labour through charging rent or interest, was ammended to mean the _excessive_ charging of interest. This is Orwellian newspeak. It is usury that is killing humanity, and the source problem for all of society’s problems that have anything to do with money.
Read Margrit Kennedy’s work–she has discovered that charging interest accounts for a 40% markup on all prices in the German economy.
Read Charles Eisenstein’s work–he writes about the nature of money and why it needs to be rethought from the very basics.
If people had any sense, they would be organizing socially to disband the banks, repudiate debt and dismantle the current monetary system to free themselves from modern-day slavery.
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