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Efficient Loans

By Dr Kevin Cox

Kevin’s interests are the result of many years of working as civil engineer, operating system support technician on supercomputers and developer of commercial personnel systems. He has lectured in systems analysis, user interface design and project development. His current research and development focus is on algorithms and complex adaptive systems. He works on giving individuals control over their online (particularly their financial) information with local communities.

An efficient loan is one where the return to the bank covers their cost, including the cost of risk, while the cost to the consumer is the lowest possible. A regular bank loan assumes the risk to the bank does not change throughout the loan, which is untrue. If it is recognised, then the bank decreases the interest rate. However, it usually doesn’t, so the bank gets a higher return than it needs to cover its risk. This results in the banks getting wealthier over time at borrowers’ expense and less money being available for investment.

Less money for investment means lower productivity because funds accumulate unnecessarily, and the movement of money slows. Some symptoms include overpriced assets, money moving to places with lower taxes, into businesses where Capital Gains are untaxed, excessive consumption of boys’ toys and criminal activity.

Today this effect means that even though we produce goods and services at ever-increasing productivity, the productivity of communities is lower than it should be.

A More Efficient Loan

We can create more efficient loans by varying the interest share between the borrower and the bank to reflect the risk. Some loans have little risk, and we can give them the equivalent of lower interest rates by sharing almost all the interest with the borrower. Amongst other benefits, it allows the banks to react to the Reserve Bank interest changes without penalising borrowers to the benefit of savers or penalising savers when the Reserve Bank lowers interest rates.

To illustrate, Figure 1 shows the following scenario: A consumer visits a bank and is presented with two choices for a $100 loan. The options are:

1. A 4% loan for ten years using existing bank rules where the bank takes all the interest

2. A 5% loan for ten years, where the bank takes 20% of the interest, and the other 80% comes off the loan balance.

4% will cost the borrower $122.44 in repayments, of which $23.46 goes to the bank. The difference between $23.46 and $22.44 in repayments is a reduction in the “invisible” Bank Capital.

The other option os 5% interest with 80% going to the borrower means the cost to the borrower is $105.38, and the bank receives $27.96 in interest. The bank and the borrower are about 16% better off than in option one because there has been less interest compounding.

What happens to the compound interest when it is generated? It is added to the Capital of the bank and is “invisible” to the loan. It is a flaw in the economic system whose goal is increasing Capital. It is not removed with simple interest because it is an emergent property of treating money as though it earned the interest rather than the borrower having to earn it before passing it on to the bank. The bank received interest earned from the borrower, which is unjust and unfair if the bank does not contribute to its production or share some of the benefits of interest with the borrower.

Central Banks should take action and use sharing to reduce the negative effect of unfair loans. The other reason is that sharing will dramatically inceas the economy’s productivity.

The Spreadsheet

You can access the spreadsheet as a view-only at this link. Please send me any questions, comments and corrections.

You can think of the loan as an object in the financial system. It intersects with different elements with changing constraints. Some of the constraints that van vary on the loan are shown in the spreadsheet. A new concept is sharing the interest to compensate for changing risks and mitigate some of the effects of compound interest.

The important equations that illustrate sharing interest are:

B9 = B8 + C8*C$4 – D8

F9 = F8 + G8*F$4 -H8

These specify how much interest paid is added to the amount owed. With everyday loans, the share (C$4) going to the bank is 100%. As a borrower, it is distressing that all of this goes to the bank – not even the depositors unless the bank decides to pass it on.

Many decision like this are being made daily within a bank, and most of them are invisible to us. We do not know how the bank divides the interst it reveices, and today we hae no way of knowing.

With the sharing approach, the bank could estimate how much goest o depositors, tax, shareholders, executives etc. and have  a real-time view of how their bank is going. At the same time, borrowers will know how they are treated and can compare with the bank’s reporting of its progress.

All of this information could be reported back in real-time to the Reserve Bank so that the population could see what is happening in the financial system on our nightly TV screens. The Reserve Bank can suggest banks adjust the share of interest to borrowers of different types of loans and adopt a zero-inflation fixed interest rate policy.

Applying the Approach to Home Loans

Figure 2 shows the result of sharing interest on home loans. There are about 6,000,000 home loans in Australia, and if all of these shifted to sharing 60% of interest with borrowers, it would mean a $36 billion per year productivity improvement in the Australian economy.

However, the more critical part of sharing the interest from home loans is that it puts buying a home within reach of all Australians when efficient loans are combined with communities forming into cooperatives of investors and occupiers. Community ownership will reduce the cost of buying a dwelling by up to 50%. This also means rents will decrease, as landlords must reduce their rentals to compete with community home ownership.

Petition to the Reserve Bank

This active petition to the Reserve Bank is open and asks the Reserve Bank to add sharing interest as another tool in their attempt to reduce inflation. Please read, and if you agree, please sign to support the action.

Open this article on Medium.