Risk plays a large part in determining interest rates on loans and other financial transactions. Two polar-opposite cases illustrate the point: high-risk payday loans and low-risk U.S. government bonds.
Let’s look at the high-risk case first. A woman, let’s call her Mary, has a job where she gets paid at the end of each month. Halfway through the month the alternator goes out on her old station wagon. She shops around and the cheapest repair is $300. Mary, a student and a single mom, has to have a car. She recently declared bankruptcy with her former husband. Her credit report reads like a horror novel. She can’t get a Visa or MasterCard and loan officers in banks and credit unions look the other way when she comes in the door. But she needs a short-term loan to fix her car.
She just needs to borrow enough to get to her next payday at the end of the month. It’s time for a payday loan.
Mary writes the payday loan company a check for $360 and the company agrees not to cash it for two weeks. By then, Mary’s paycheck will be deposited in her account and the check will be good. But the loan company will give Mary $300 cash. That’s right, just $300. The check-advance loan fee is $10 per $100 per week, so $300 for two weeks is $60. Of course this is not really a fee, but interest on the loan. The annual interest rate is about 520 percent.
Uncle Sam is like Mary with a bad alternator. He needs a loan, too. He’s spending more than he collects in taxes. Budget surpluses have turned into deficits again. But when Uncle Sam borrows, he has more choices than Mary does. For a short-term loan, Uncle Sam can now borrow at an interest rate around 3.5 percent.
That’s quite a difference, 3.5 percent for Uncle Sam and 520 percent for Mary. It doesn’t seem fair that Mary, down on her luck, gets gouged with a payday loan and the government borrows at low rates. But much of this difference in interest rates is the relationship between risk and return.
There are many kinds of risk in loan markets. The most important is the risk of default, where the borrower doesn’t pay back the loan. Given Mary’s credit history, a loan to her is very risky. By contrast, Uncle Sam has never defaulted on a loan and is very unlikely to do so in the future. If the government gets into trouble, it can always borrow more, and it always holds the trump card of creating money in cahoots with the Fed.
Given these large differences in risk, lenders tack a risk premium onto the interest rate on Mary’s loan to protect themselves. But isn’t this risk premium a little excessive?
Here’s a fundamental principle of financial markets: After adjusting for risk, all interest rates are pretty much the same.
If the 520 percent interest rate to Mary was a great deal for lenders in terms of risk and other cost differences, there would be payday loan shops opening on every corner. Such an increase in the supply of payday loans would drive down the price of these loans (because interest is the price of credit) until it wouldn’t pay anyone else to enter the industry.
In a social sense, we might be concerned with the level of financial desperation that drives people to the payday loan window. But in an economic sense, everything seems to be in order. Loan companies are lending their own money, borrowers are coming in the door by choice, and the number of payday loan companies is not exploding.
An important result of the relationship between risk and return is that no free lunches exist in financial markets. Receiving a higher return on a financial investment often means accepting more risk. Remember the principle that, except for differences in risk, all rates of return are the same? Very smart people all around the world keep their eyes and their programmed computers focused on risk-adjusted rates of return. If rates of return move out of the range justified by differences in risk, these smart people sell the losers and buy the winners, driving up the rate of return on the former and driving it down on the latter.
The relationship between risk and return is not just something economists and professional financial managers need to know about. It’s one of the important practical principles of personal finance. When someone wants to sell you a high-return asset — either at an investment seminar, in your living room, after church, or in an advertisement — your first question should be “What’s the risk?” Because if you always pursue high rates of return without knowing that the returns are high because the risk is high, it won’t be long before you’re standing next to Mary at the payday loan window paying 520 percent interest.
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