Long time ago I had the “stupid” thought about what would it happen if we change the whole Financial System and introduce Linear Interest as the basis instead of the typical compounding interest rate. I thought directly that the bunch of economists and financial people should be quite intelligent and some kind of incentive-making is what makes this compuning system work and it has no sense to think about it. Indeed, incentive society to work and take risks should be the basis of any Financial System.
Well, from a time to now I have been seeing some circumstances that at least make me challenge that assumption. Maybe it is not so stupid to change it all in order to make it work better.
First of all, compound interest lead the finance calculations to non linear calculations that in the end make confusing what we are dealing with and make it necessary to use spreadsheets or financial calculators. Secondly, in that maths game we lose control of what is it that we are dealing with, when it is something so simple as I need cash, you lend me cash, I give it back to you or I need to be sure that guy is going to pay me so I involve a bank or a insurance company in order to guarantee the payment. Thirdly, the one who suffers more this kind of lack of vision is the weak (I correct, not wealth) person instead of the wealthy.
Let’s think about it for a minute. A wealthy person doesn’t need a loan indeed for personal needs and when it is a loan for investment.
What is it happening with the not so wealthy?
Compounding interest takes into account the value of time, if you owe me capital that I could be using right now, I’m having a cost of opportunity, so far so good, but what happen is that banks and lenders in general tend to impose abusive rates of interest when something happen than avoid the borrower to repay the loan, firstly they usually charge a bill of around 30 €, independently of the quantity that is owed, just for the fact. This fine that could be seem as logical as “that guy didn’t respect to do his payment this month” turns out to be evilish “maybe that guy was in a bad momment and with the fine you put to him you are stabbing a weak do in its back”, also with this situation banks usually charge interest rates on the delay of 20%, 25%, 30% which make the situation quite worse.
It is obvious that the implications are huge and we would need a couple of books to make an extense analysis of this. Maybe compounding interest is better in many situations (we cannont forget that it takes into account the value of time) but in other situations like these where people that are not in the better situation within the economy, and the people we as society have to help to thrive in order to approach the more than necessary social equilibrium, maybe in these situations a simpler linear interest could be better.
As an example let’s think about a mortgage. Well, you have a house which price let’s say is 100.000 $, with the typical French system you pay part of the capital every month fixing the quota but let’s think about a simpler German system where you pay let’s say 1.000 dollars in capital every month during 100 months. With a 12 % nominal interest for example, the first month you’d pay additional 1.000 dollars, being decreased this interest in 10 dollars every month, so after 100 months you’d have paid 100.000 $ in capital and around 50.000 $ in interest in the case you paid every mensuality. Let’s think that you are fired from work during the first 10 periods of the loan, in this dramatic case, you’d have another 10.000 $ debt just in interest…. Not exactly…. because the owned 10.000 $ would allow the bank to charge let’s say 30 % in unpaid quotas, adding up to probably 30.000 $ new debt (well depending how you apply this interest, it could be less but no less than 15.000 $) In any case, whatever the number, you have made a not rich, but normal person, really poor… you as society, in the incarnation of a bank has destroyed a productive human being transforming his equity into a huge debt and in the end you, the individual will end up losing the house and all hopes in life.
It is true that the counterparty could have used those 100.000 dollars to buy a bread machine and then you are paying for the cost opportunity… well it looks fair, but if you look at the final consequences, the cost you are paying as Society is far more high than the cost of opportunity.
Maybe in order for this to work and everybody to be happy some government plan should be backing this loans to people in risk, let’s think about and improved version of the Americans Fannie Mae and Freddie Mac plus protective legislation that would impose to study every case of every person that would not pay let’s say three months on a mortgage and not, please, killing you with 30 % interests plus 30 € fees plus interests on the interests. Maybe this is the base of another article and a brand new financial legislation.
Let’s now think in the mortgage that you as a person took in the example 100.000 $ loan, well now let’s apply a linear interest…. In order to kinf of taking into account the time value of money, let’s put a 50 % of interest, so 150.000 $, now let’s divide it by 100 and you have it, 1500 $ per month during all months. If you make the calculation (i*(1+i)^100/(1+i)^100-1) of the French compounding method you’d obtain something similar and then so far, so good, in normal conditions, with a linear interest of 50 % you are having the same benefints as Society than under the compounding interest but having make it clear cut… Human beings are Psychologic beings and if you don’t think it for a while, then 50% interest looks like quite more than 1 % monthly interest and I think is good that people know what they are doing without too much thinking.
In this linear interest let’s suppose you lost the work for the same 10 months, here the difficulty arises on how to penalize for this delay, we have to be creative, but let’s try to protect the guy without penalizing the society too much for not using the capital, then a formula could be we create this agency that study the case and bail you out during these months, owing then to the agency the 15.000 euros and put here a 3 % annual, compounding in this case, interest in order to adjust for inflation (it should be floating but for keeping it simple) interest on the delay… well you’d have no extra debt, you’d just have a debt of 15.000 with the agency and when you would go back to work as a fresh and valuable men that you are (not as a corpse) you could continue paying 1500 dollars to the bank and you’d have a debt of 15.000 $ with the agency (well, I have to tell that it’s obvious that any case should be analyzed in order to avoid moral hazart, but thinking about that there are a 97 % of the population that has a moral view of life, it’s of a extremely low probability that more than a 1 % of the cases would try to do some kind of Shenanigans and with the correct legislation you can make this go to probabilities near to zero in the order of 10-20 cases per year over a population ob 5 billion, maybe it would worth it)
Following the example, now you would go on with your life and the Agency that bailed you out would recover the 15.000 let’s say in 2 years, making a total delaying cost of aroud 600 monetary units… nothing to do with the numbers we saw in the part of the example with the current conditions.
In the end this example looks like a win-win, you keep the time value of money as society, you keep your life as an individual and you as an Economy don’t lose a valuable asset (a productive person who in ruin would be unproductive) and what for me is the most important of all issues, you protect the weak in his weakest momments.
Bankers, Lawmakers, Financial responsibles from the world, please just think about it and with a flexible mind. I don’t want to have to write more articles such as http://aglimpseoflightintothedarkness.wordpress.com/2012/05/25/desperate-suicide/ among other things because I’d like to concentrate on the posiviteness of solutions, and we as Society have a lot of light in front of us, the future is showing with amazing technologies like the one that permits that I can write this and share it in just a minute. But I can’t close my eyes in front of these dramas created by us in the benefit of financial advances, well let’s take a minute to correct the little mistakes that we created while creating financial advances.
And nobody think for just a minute that I made a mistake using the pronoun “you” in both sides, the lender and the borrower