Finance 101: follow the interest rates, or carry is king

Interest rates are all the rage these days in the media: various countries are cutting base rates to below zero (an idea once thought impossible, called ‘the zero bound’).  The latest culprits are Scandinavian countries Sweden and Denmark – their economies are closely tied with the Euro-area, so the quantitative easing from the latter increases pressure on the Scandi countries’ exporters.  Enter negative base rates.  Longer-term interest rates have fallen as well, with multiple governments now able to borrow at near-zero for 10-year loans.

With all this in mind, let’s consider the big picture, and implications for individuals.

  • Definition: an interest rate is the cost to the borrower for getting money now, rather than later.  Seen from the other side, the interest rate is the return to the lender for giving up money now, rather than later.  The interest rate is an example of carry, or the return to an investor for holding an asset (in this case, a loan/bond).
  • Usage: we can use the interest rate to help judge one debt versus another.
    • Borrower’s perspective: suppose you have several loans outstanding, or need to borrow, and are considering different types of loans.  Some examples, with typical interest rates are below, in descending rate order:
      • Payday loansaround 400% interest per year.  No security needed, and very short term.
      • Credit cardsaround 15% interest.  No security needed, and short term (balances can be rolled forward, as long as credit card company allows).
      • Peer to peer loansaround 10-15% interest.  No security needed, and medium term (3-5 years).
      • Student loansaround 5-10% interest for Federal loans; 7-15% for private loans.  No security needed, though sort of the ultimate security: you can’t get rid of these loans through bankruptcy.  5-15 year term.
      • Home equity loansabout 6% interest.  They’re 2nd mortgages on your house. 5-15 year term.
      • Auto loansaround 4% interest.  Car title held as security; medium term (3-5 years).
      • Home mortgagearound 3-4% interest.  House title held as security; long term (15-30 years).  In the US, mortgage interest is tax-deductible at your highest marginal rate, so the effective interest rate may be much lower.
      • In sum: if I had several types of debt outstanding, I would probably pay them off in the order above.  If I needed to borrow, I’d probably borrow from the bottom up.
    • Saver’s perspective: suppose you have some cash to put to work, and are choosing between the options.  Rates help us here, as the interest rate is the maximum return you will receive on your investment.  There is a clear risk – return trade-off, though.  Anyway, in ascending order of interest rate/risk:
      • Savings accountabout 0-1% interest.  Instant access, and government-insured.
      • Certificate of deposit/fixed savings1-2% interest.  Government-insured.  1-5 year term.
      • Government bonds (Treasuries)0-2.5% interest.  Government-issued.  30 day-30 year term.
      • Corporate bonds1-6% interest.  ‘Proper’ credit risk – you may not get back what you put in.  Typical 5-year term.
      • Peer to peer lending5-15% interest.  Lending to ordinary folks, with no collateral.  3-5 year term.
      • In sum: pick your poison.  If you need the funds at any time (e.g. an emergency fund), better to stick with the earlier entries on the list.  If you’re looking for more risk, head on down the list.  Keep in mind rates are at all-time lows in most places, so maybe keeping with short duration (i.e. sticking with shorter-term stuff) is a safer play.

There you go.  Other types of carry (e.g. dividends, rental yield) we can pick up later.

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