07 November 2008

Zero Interest Loans

One of the mysteries of the economic universe is the zero interest loan.

I don't mean that zero interest loan from your mother or your lover or your uncle or business colleague. These are simple gifts based upon a principal of reciprocity and mutual obligation. Similarly, zero interest or low interest loans offered by non-profits and government agencies are frequently an intended form of subsidy designed to leverage a lot of benefit, with a fairly modest cost to the provider.

I also don't mean that zero interest loan that is tied to a particular purchase, like a zero interest loan from a car dealer in connection with a new car. This is simply deceptive labeling. When you get a zero interest loan you are simply paying a higher purchase price up front, in lieu of interest. In the case of a car loan, or a home loan with a teaser interest rate, the trade off between a lower purchase price or zero interest financing is often even expressly offered to the customer.

What I mean is a genuine (usually unsolicited) loan offer from an unrelated party, like a credit card issuer, usually on a balance transfer, for a fixed period of time, with no balance transfer fee (or a nominal one far less than any market interest rate would generate), with no pre-payment penalty or obligation not to transfer the funds when the zero interest rate expires.

It isn't that I don't understand that there are ways for a credit card company to make money by offering zero interest loans. If you don't pay down your loan quickly and stay with that company after the zero interest rate expires, you end up paying interest to them instead of someone else. If you miss a payment or otherwise trigger a default (for example, under a universal default provision of the card agreement), they can charge you interest even sooner at an extra high default interest rate. If you have a card from the company that you transferred a balance to, you may also end up using the card to make new purchases upon which the card issuer earns merchant fees and interest on balances that aren't paid before a grace period expires.

But, offering a zero interest loan is not cost free to the offering bank. The offering bank assumes the risk of default on your loan, and default risk is higher than ever, particularly from people who are carrying balances on high interest credit cards that they need to transfer. In addition to the default risk, a certain amount of money must be spent to issue statements and processing payments. Finally, the offering bank must pay someone else interest to let the bank use the money that is loaned to the customer. The bank also has to pay considerable marketing costs to send out millions, or even billions of these offers to customers, in the hope that customers will do business with them. On a $10,000 balance transfer with a one year zero interest period, this may cost the bank several hundred dollars in marketing costs, processing costs and its own borrowing costs. If the program is to be profitable, these costs must be recovered somehow.

What surprises me is that these offers actually work to generate profits for the bank (and if credit card companies are offering them, presumably they do . . . although I've seen many of these offers come in my mail from Washington Mutual whose loose underwriting ultimately caused the bank to fail). Indeed, this may be remote evidence of the rather well established economic fact that executive compensation is more closely related to the scale of an enterprise than its profitability. Executives at marginally profitable or money losing big businesses are often paid better than executives at smaller business with a good return on investment. So, managers have an incentive to increase market share and hence the scale of the business, so long as the company doesn't lose so much money that it goes out of business.

Still, generally, financial companies are exceedingly wary of transactions that a consumer can control in a way that denies the financial company any return. This kind of deal, that allows a consumer to get a substantial benefit without anyone obviously paying for it, with no strings attached, is something that financial companies generally go to great lengths to avoid.

For example, individual health insurance policies almost always include a huge premium, with significant "pre-existing condition" exclusions and limited coverage for maternity coverage, on the theory that the insured can otherwise get a huge bargain by buying maternity coverage only when the insured is or is about to become pregnant, and then cancelling the coverage as soon as a child is born and home safe. It isn't unusual for premiums to be so high that all the expenses attributed to a healthy child birth are recovered in eleven months. Dental care policies are similarly cagey about offering benefits for major dental work that can be deferred or anticipated by an insured.

Yet, big national banks, which often have business partners who offer health and dental insurance, offer to let you have their money, use it for free for six months to a year, and then move on to another bank, paying them nothing but principal payments on the loan in the meantime.

Part of me wonders if these kinds of programs are designed collusively by the industry as a whole, as another arm of the Consolidated Credit Corporation program funded by credit card companies to encourage self-help repayment on favorable terms by debtors instead of bad debt and bankruptcy by debtors who are crushed by high interest rates. But, I'm not away of any such collusive activities, and if they did exist they would seemingly violate anti-trust laws. Is there some secret special rule that allows issuers within the credit card processing system to charge back losses on balance transfers within a certain time period or something? There are no such arrangement of which I am aware.

I also wonder how balance transfers interact with the luxury purchase rule in bankruptcy that denies a discharge for large luxury purchases and cash advances made on the eve of bankruptcy. Does a balance transfer of a debt incurred for a luxury purchase made on the eve of bankruptcy retain its luxury purchase character with the new creditor? Does a balance transfer count as a cash advance for bankruptcy purposes? Has a bank accepting a balance transfer rendered your debt to them non-dischargable without disclosing that fact? I haven't researched the issue, and I'm not even sure that there is settled law resolving the issue uniformly in all jurisdictions. But, my gut instinct is that the balance transfer paying bank is in a worse position in bankruptcy than the original creditor and does not receive these benefits.

I wonder about the strategic behavior by credit card consumers mostly because that is the only way that I have ever seen anyone use these kinds of offers. People with really bad credit don't get them. People with good credit who are carrying credit card balances are usually savvy enough to use them in a ruthless and strategic fashion with no regard for the bank's well being. Presumably, there are less savvy people out there, or the forces in inertia and the odds of simple mistakes that trigger fees and interest are greater than I would assume. But, I honestly don't really know why the genuine zero interest loan practice helps credit card companies make a buck, which is potentially relevant far beyond this particular niche zero interest loan pheneomena, because it may illuminate a great deal about how these companies really make their money.

A comment from anyone who can direct me to credible sources describing the economics of these transactions would be appreciated. One news report I did find on the practice (at a California bank for business loans) identified a low cost of funds for the bank as an important factor making the program work.

2 comments:

Old Bogus said...

They make money because most people aren't so diligent in keeping track of how long they've had the 0% card so don't concern themselves until it starts producing interest charges. Then they often have to wait for an offer before the transfer. So card company gets some interest before the balance zeroes. And no defaults.

But a certain percentage never zero the card but continue to use it adding to the balance; I suspect that % is not insignificant. You can bet the the payoff/risk ratio is enough that the card company is NOT losing money.

Kevin said...

While not the same as the loans you are discussing zero interest loans can be made that are very profitable to a bank that offers them.

The reason we pay interest on loans is that most money that is created is what some people call "credit money". That is, someone takes out a loan that is backed by an existing asset. In effect the person taking out the loan "rents" out their asset and person giving the loan expects a return on their money because you are renting your asset back to yourself.

The system works well but what if we had a guaranteed way of creating a new productive asset. What interest rate should we charge on the money to create it? Well we do this today and it is called equity financing. If I want to build a new productive asset that does not yet exist I cannot get a regular loan because the asset does not exist so I cannot rent it out so I sell, through equity, part ownership of the future asset.

However, conceptually there is no reason why banks cannot give zero interest loans to create new assets because the rent on the money created for the loan should be zero because the asset does not yet exist so the loan is backed by zero assets and it is not fair to charge rent on something of zero value.

Banks could finance new assets this way if the money that is created for the loan is guaranteed by the issuer of the currency and the money until it is spent should itself not earn interest. That is the government guarantees the money not the loan and the money is non interest bearing until it is spent.

Of course everyone would want such loans and they would be easily abused so to make such a system work the right to zero interest loans should be a privilege and could be given to equally to everyone in society and they in turn would agree that they would only use them for something of use to the whole community.

The thing everyone wants today is renewable energy and so zero interest loans could be given provided they are only spent on ways to generate renewable energy and the loans paid back from the income generated from selling renewable energy. Renewable energy from facilities built with zero interest loans will be very very profitable as there are no finance charges.

What this then does is stimulate the economy, and at the same time go a long way to solving the climate change crisis.