Many people who are in the general public don’t like “bankers” but without them, it is very difficult to build wealth and for a modern economy to function. Money is the means with which we engage in trade- it enables two people to trade goods and services.

Money permits the farmer to barter for medical services without having to travel to the doctor’s office with a lamb in tow to use for barter. It permits the doctor to barter with others for things that can’t readily be traded for- the doctor can’t mail a leg of lamb to the electric company, and it’s difficult for the electric company to barter with a bushel of electricity.

Once we admit that money is a necessary commodity that permits modern trade, we also realize that we sometimes don’t have enough liquidity to make large purchases. In these cases, we find someone willing to loan us the money. Seldom do we have friends and family that have enough in liquid assets to loan us money for a house or a car, so we enlist strangers and acquaintances to loan us money.

Those people aren’t going to loan us money without knowing the risks of not being repaid. They evaluate that risk, and looking at people with similar financial profiles, determine how risky it is to loan you money. That is, how likely is it that you will default on the debt and walk away with their cash? So let’s say that the lender determines that people whose financial situations are similar to yours default on loans 1% of the time.

The lender needs to be compensated for his administrative overhead, the risk he is undertaking, and still have enough for a profit. If he were to invest that same cash into a mutual fund, he would have significantly less risk and expense, so he needs to make more than he would make investing in that mutual fund.

In this case, the mutual fund would pay 2.5%. The lender’s overhead is another 1%. If the lender doesn’t get to charge at least 3.5% interest on this loan, he is only breaking even with that mutual fund, and that doesn’t even account for risk.

In order to measure risk, the lending industry has developed credit scoring, with Fair, Isaac, and Company (FICO) being the company with the most widely used scoring model. Let’s look at default rates for different FICO scores:

Credit Score% of the populationprobability of default
800 or more13%1%
750-79927%1%
700-74918%4.4%
650-69915%8.9%
600-64912%15.8%
550-5998%22.5%
500-5495%28.4%
less than 5002%41%
Credit Scores and Default Rates

You can see that loaning money to people with a FICO score of 700 or higher means that you have a 6.4% chance of losing your investment. Using the numbers from our example above, if we were the lender, we would have to charge 9.9% interest to get the same 2.5% we would get from that mutual fund. In this case, we have one of two choices: we can lend to people with a 700 credit score or more, but at 10.9% interest, or we can loan to people with a 750 FICO or higher, and because the risk is lower, we could offer loans at 6.5%.

The issue here is that only 40% of the public has a score of 750 or higher, and everyone wants to lend to them because the risk is so low. For those reasons, competition is fierce for their business, and we will likely only be able to charge 5.9% for loans without collateral, and 5.7% for loans with collateral, because collateral reduces our risk.

This is of course a simplified example, but it does show that this is a simple math problem that balances risk with reward. This doesn’t mean that bankers are evil.

Let’s suppose that you had a chance to choose between two employers. One offered to pay you $20 an hour, and there was a 99% chance that your paycheck would cash without a problem. The second employer offers you $100 an hour, but there is a 35% chance that your paycheck will bounce. It’s a choice that you want to be careful with.

Banks do the same thing. Why would someone loan you money unless there was a reward for them doing so? Anyone who has loaned a friend or family member knows that there is a chance they will never see that money again, and that is for people you know. Absolute strangers are even more likely to walk.

I discovered that myself when I invested money in some peer to peer lending on Prosper.com. I put $500 into that website, loaning that money by partially funding several different loans. The terms there are simple- people see the credit scores of lenders, and bid on funding those loans at whatever interest rate they are comfortable.

So let’s say that you want to borrow $1,000 and your credit score is a 740. There is a 6.4% chance of a default, so the bidding begins. Your loan is funded by 30 people who offer to lend you the money at 8.9% interest. You have to repay that loan in 36 months, with a monthly payment of $31.75. At the end of the three years, the people who funded your loan would have received $1.10 in return for every dollar that they loaned you- a profit of 10% over three years. (some of the interest charged is given to Prosper to cover their expenses)

If you only make a year’s payments before defaulting, each dollar invested would only return 69 cents, meaning that the investors lost 31% of their investment.

That’s why interest gets charged, and a basic idea of how it’s calculated. If interest wasn’t charged, then there would be no money to lend to anyone.

Categories: economics

23 Comments

Rick · September 2, 2024 at 4:13 pm

I am of the firm belief that a business which folds, does a disservice to the community. I hold this especially true for small business.
It takes money and acumen to stay in business. A business without profit will eventually fail.

The absolute crappy part of that is most people do not understand that.

Dan D. · September 2, 2024 at 4:15 pm

The first commercial program I wrote, while still in college, was for real estate and mortgage lending. I’m a physicist/programmer not a financier so I had to learn everything.

The most important thing I learned is that in the first years of your home loan, making effectively 13 payments/yr (with the additional going to principal) dramatically reduces your N year loan.

Trying this later into the loan is almost pointless.

Just my experience to share.

Anonymous · September 2, 2024 at 4:19 pm

That is all very true and should be a basic understanding of borrowing and lending. Consider though, that bankers with fractional reserve lending INVENT the money they loan many, many times over. The interest charged on all those many, many loans provides for some quite bespoke suits and expensive lifestyles, without ANY actual cash in the bank.

Reserve requirements went to zero early in the Covid period. Even in the once upon a time 10% reserve requirement, the same dollar would be relent into existence and interest charged on the several loans multiple times. There is risk that the borrower won’t pay or that the depositors will all show up on the same day to withdraw. Until that happens, bankers have a most sweet deal going.

Nightraker · September 2, 2024 at 4:43 pm

Very true. Recall, however, that credit card companies call “Deadbeat” not for the schlub who defaults but rather those who pay the entire balance every month. With Fractional Reserve Lending the banker gins up the money for any loan out of thin air. During COVID, reserve requirements were set at zero. Barring massive, general defaults or alternatively a bank run, a banker’s very generous income from the interest is based on an accounting gimmick.

When George in “A Wonderful Life” protested that the money wasn’t in his Savings and Loan but rather in your neighbor’s roof or some such, he was being accurate. There is no money, really, in a bank, but rather a very closely organized set of books.

it's just Boris · September 2, 2024 at 5:12 pm

I think your math is a little off re the likelihood of default for the population with credit scores above 700. Weighting the default rate by the fraction of population, I get an average default rate of 2.05% = ( (13% * 1%) + (27% * 1%) + (18% * 4.4%) ) / (13% + 27% * 18%). Just offhand, I don’t think you can get a group average that’s higher than any individual entry in the group; in this case, the highest default rate in the group is 4.4%, so it’d be hard to get a net default rate of 6.4% for the group.

In the case of the hourly wage, so long as I got paid fairly frequently, that’s an easy choice – go for the employer paying $100 per hour with a 35% chance of failure to pay. (Or, put around, that’s a 65% chance of getting paid.)

The expected long-term hourly rate (e.g. averaging over many pay periods) is the hourly rate times the likelihood of being paid. So for the one employer the long-term rate is ($20/hr * 99%) = $19.98 / hour. For the other it’s ($100/hr * (100% – 35%)) = ($100/hr * 65%) = $65/hr. More than three times the expected long-term hourly rate from the first employer.

    Divemedic · September 2, 2024 at 5:42 pm

    I don’t think you weigh them.

      It's just Boris · September 2, 2024 at 7:55 pm

      Well, since the probabilities (default rates) sum up to 123%, it’s not a cumulative distribution. But even if it were, the categories would be listed as, say, “700 and above,” not binned like “700-749”, “750-799” etc. The highest bin is indeed presented as a cumulative, but none of the others are … and it defines the end of the range, so it is, for practical purposes, just another bin.

      There’s a typo in my first formula, the three percentages in the denominator should be summed; the 2nd and 3rd shouldn’t be multiplied.

        Divemedic · September 3, 2024 at 5:49 am

        Perhaps you do. The overall default rate for a credit score of 649 and below using your formula for is 21.9%.
        As you point out, the default rate for 700 and above is 2.05%.
        The overall concept still holds. It isn’t about good, evil, or greed it’s simple math. The lender wants to get paid. They don’t want your collateral, they are there to make money, not take houses.
        Are there banks who were breaking the law? There sure were. The stories of my experiences during the 2009 mortgage collapse are valid proof of that.

    Divemedic · September 3, 2024 at 3:16 pm

    I didn’t even see the part of the comment about the job. Sure, there is a 65% chance that the paycheck clears, but that is for a single occurrence. By the time you have received your sixth paycheck, the odds of at least one of them bouncing is 93%.

Exile1981 · September 2, 2024 at 6:41 pm

My complaint is when the government sets stupid rules. Like telling banks they have to loan to certain people who are high risk as if they are low risk.

Or lately banks are not looking at market value of property but liquidation value. So say your house is worth 250k normally you could get a loan for 80% or 200k. I have my mortgage down to 100k and wanted to renegotiate at a lower rate, bank told me while the house has gone up to 400k value they now only loan outside cities based on liquidation value. Since they say they would have to liquid my house to 100k to sell within 30 days of foreclosure they will only loan 80% of the 100k. Even though i’ve been with same company 8 years and am a 790.
Two different banks gave me the same story based on being rural.

    Rick T · September 2, 2024 at 8:11 pm

    I can confirm Exile1981’s report. I just spoke to my mortgage company about an HELOC and the banker told me they will loan a maximum of $75k for homes an appraiser rates as ‘Rural’. The banker didn’t mention liquidation value but that makes some sense. I have a ARM with a low initial rate and a 10 year lock so I really don’t want to do a full refinance and get marked to market rates.

grumpy51 · September 2, 2024 at 6:51 pm

What was your overall assessment of crowd-lending?? Something worthwhile investing in??

    Divemedic · September 3, 2024 at 5:41 am

    I lost the majority of my investment. My feeling on it is that the banks are quite good at determining who is credit worthy, and if they aren’t willing to loan someone money, there is a good reason for that.

      TB · September 3, 2024 at 3:05 pm

      Thanks for sharing. I came to comment to ask this exact question. Have considered for a while but I thought about the kinds of people willing to pay 12% for $1000 for 4 mos. Plus, my state doesn’t even allow P2P lending/investment.

        Divemedic · September 3, 2024 at 3:11 pm

        Prosper’s loan terms are always 36 months, but the people who go there for loans have already been turned down by traditional lenders.

SiG · September 2, 2024 at 9:17 pm

Lately, I’ve been going through the same modeling except not about banking but insurance. In particular, dental insurance and trying to find scenarios in which it makes sense for me to pay for it. A lot of the same concepts are at play, but there are some important differences.

    Grumpy51 · September 3, 2024 at 10:44 am

    I just went through this (2023). My insurance cost X with max payout Y. I took the insurance as I knew I’d be having oral work done. Only saved me about $200 and was a major pain for my dentist (he took it in stride, saying this was their normal operating procedure, though I felt bad for him, taking so much time – 4 months – to pay). In general, I do NOT do dental insurance as my twice-annual checkups cost MUCH less than what it’d cost me for insurance.

    TB · September 3, 2024 at 3:46 pm

    Dental insurance is a weird one. My plan has $1000 annual cap with no carry-over. Premium is bundled with medical from employer so no way to break it out. It’s enough to cover annual cleanings for all of us plus a filling or two between us per year.

    Related – between my cost and employer’s contribution, medical family plan is $503/wk or $26,200/yr. How’s that for a scam. Plus, it’s up 146% – double and a half – since my first paycheck with them in 2017.

TCK · September 3, 2024 at 3:51 am

To be fair, plenty of bankers are in fact capital E Evil, your own experiences that you’ve shared previously confirm that much. Unfortunately, far too many people take that as an excuse to claim ALL bankers are evil. Even more unfortunately, those same people often claim that politicians and government bureaucrats are any better.

    Divemedic · September 3, 2024 at 5:57 am

    Sure, there are evil people in every profession. There was a nurse who was injecting bags of IV solution with insulin and putting the bags back into storage. They even made a movie and a documentary about it.

    The mortgage backed securities of the early 2000’s are proof of that.

      Barbarus · September 3, 2024 at 1:28 pm

      Trouble is, too many people think evil bankers are the ones who foreclose on a struggling business that the owner is sure is going to turn round “any day now if only he can raise a little bit more”. No, evil bankers are the ones that lend other people’s money to businesses like that, take the salary and bonuses, then walk away whistling when the bank collapses because of the bad loans and the customers lose their savings.

McChuck · September 4, 2024 at 9:33 pm

The real problem is that banks place 100% of the risk on the borrowers. The bank invents the money to loan out of nothing. (Banks haven’t needed to have real money to loan out for decades.) If you default, the bank can use the law to make your life miserable, but they lose nothing except a lost chance for profit. From digital bits the loan came, to digital bits the loan returns. The only real money involved is the never ending compound interest payments you make.

Oh, and the model used in the example only accounted for simple interest. Compound interest completely changes the game.

    Divemedic · September 5, 2024 at 6:37 am

    1 I know the example included only simple interest. While compound interest makes the amounts change a bit, the principle remains the same.
    2 What you are referring to is called the credit creation theory of banking. While the theory does permit a bank to “create” money out of thin air when they create a line of credit, if that line of credit is not repaid, the depositors need to be made whole, and that comes from “real” money that is on deposit.

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