Posted By Mimenta on December 26, 2016
“Sure they might be ethical but are they right morally. Is it right to charge 20% interest when the banks are charging only 3%?”
That’s what a sceptical friend posed to me, at a meeting one day. I have to admit I had a slight niggling feeling about the morals of it all but when we are making money, it’s amazing how we can rationalise away out morals. I came back with the usual responses like, “Well no-one is forcing you to borrow it. You don’t say that about the tax man when he takes a whopping 33% and shells it out to politicians.”
Then another member of the group spoke up and what he said changed the whole perspective for all of us:
“My wife and I have been paying off our home loan for 6 years now. It has a redraw facility that allows us to top up the loan and draw out some of the money we’ve repaid. We decided to get a better car and looked at using some of that equity to purchase it. We needed about ten thousand dollars. At first it seemed like a good idea to use the equity in the home loan. After all, variable rates are so low now and it’s only 6% p.a.. The alternative was to get finance for a car loan at 19%.”
The whole group agreed. It made sense to make use of a lower interest rate. But the next sentence stopped us in our tracks.
“Yes! You see you’re sucked in, just like everyone else. Fooled by the magic of compounding interest. I nearly was too!”
We all looked at each other trying to see what we had missed. No way could a loan at 19% be better than a loan at 6% right?
He explained, “You see, while you see the interest rate, you are forgetting the term. The home loan will take that $10,000 at only 6% but for 19 years! Sure the finance loan is a lot higher interest rate, at 19% but the term is only 4 years”.
We still could believe it was cheaper, so I pulled out my smart phone and set up the compounding interest formula. If he borrowed $10,000 at 6% compounding over 19 years, he would repay $31,178.99.
Then I did the calculation for the same amount at 19% for 4 years and discovered he pays only $21,255.83. In other words by taking the high interest loan, he’d save a whopping $9,923.16.
The difference is the time the compounding takes or the term of the loan. Morally there is nothing wrong with lending at high interest rates provided they are only for short periods. The added advantage with P2P loans is they don’t charge whopping penalties for early repayment either, like the finance companies and banks do.