A Comprehensive Guide to Loans and Lending
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Money is what we use to exchange with one another so we don't have to trade goods and services directly. It allows us to avoid the awkward situation of offering things like corn to the dry cleaner as a means of payment. Odd, but true. Money is our primary means of exchange and we use it to purchase real estate. The issue we run into is that purchasing real estate requires large sums of money we rarely have, and therefore we need to borrow money. This falls under our current topic, financing real estate.
There are many ways to finance a property purchase, and there are also important governmental regulations that control real estate finance. Before we discuss these, let's first establish what the market for money is and how it's created.
Just like many other goods and services, there is supply and demand for money. The demand for money is driven by how many people need and want dollars. Dollars are needed for capital purchases, such as equipment or plant construction; even foreign companies require dollars so they can pay US-based companies for goods and services. Homebuyers and commercial property buyers also require dollars so they can pay for their purchases.
The supply of money is controlled by the United States government through the operations of the Federal Reserve and the Treasury Department. The Treasury Department is in charge of minting (creating) money, and acts as the country's money manager, paying employees of the government and collecting taxes. The Federal Reserve controls the credit in the economy. Because the Federal Reserve controls the credit in the economy, they have a larger role in determining the amount of money available.
The Federal Reserve System ("The Fed") is the central banking system of the United States. The Fed was created by an act of Congress and operates independently. The Federal Reserve is tasked with the goal of maximum employment, stable prices, and moderate long-term interest rates. It does this through monetary policy, which it implements to control the cost of credit in the country. While this is done in a number of ways, it is primarily influenced by the federal funds rate, the interest rate banks charge each other for short term loans. When you hear on TV that the Fed has raised or lowered rates, it is the federal funds rate they are talking about. It is vital as it relates to real estate since the cost of credit ends up affecting mortgage rates and the economy. There are various economic reasons behind the Federal Reserve's decision to raise or lower rates, in keeping with meeting their obligations of full employment, stable prices, and moderate long-term interest rates, but these are outside the focus of this course.
Interest rates are affected not only by the action of the Federal Reserve but also by acts of Congress and the President through tax and spending policies. The federal budget and taxation are known as fiscal policy. Fiscal policy has an effect on employment, economic growth, and the size of our deficit. Interest rates are affected by fiscal policy through its debt management, spending, and economic effects. It is typically assumed by economists that fiscal policy affects the economy but does so on a much slower timeline than monetary policy. The effects of tax increases or decreases are not immediate and any structural shift Congress enacts is likely to take quite a while to take hold and even longer to evaluate. Fiscal spending can go to a number of areas so the legislative and executive branches have an opportunity to target specific industries and geographic locations to help stimulate the economy.
Money has a cost. It costs money to borrow from others because they charge interest as a condition of lending. Interest is paid by the party borrowing money because finance follows a basic principle: money now is worth more than money later. Essentially, the party lending the money wants to receive more money in the future since they are foregoing the opportunity to use and enjoy the money now. Conversely, the borrower pays extra to enjoy someone else's money now. Because the economy in the US is so large and robust, interest rates are whatever the market will bear through supply and demand for return.
The nominal interest rate is an annual rate quoted in percentages. The simple interest method does not consider the effects of compounding. This method calculates interest as the product of the original balance, the nominal interest rate, and the time period (in years).
Consider a $5,000 savings account balance with a 12% nominal interest rate, using the simple interest method. In one year, your account would equal the interest payment of $5,000 x 12% = $600 plus your original balance of $5,000, for a grand total of $5,600.
Let's suppose you could request to be paid in half of a year. In this case, your balance would be $5,000 x (1 + 12% x 0.5) = $5,300. As you can see, when you use the simple interest method, the yearly interest of $600 is exactly double the semi-annual interest of $300.
To generalize, simple interest can be computed once you know:
The balance of the loan or savings account (P)
The annual nominal interest rate (r)
The time in years (t)
The general formula is:
Balance after t years = P * (1 + r t)
Compound interest is calculated very much like simple interest, but it takes into account that the balance changes each time interest is paid out. If you consider the simple interest example at 6 months, the interest paid was $300, creating a total balance of $5,300. At the end of the year, the balance is $5,600 under the simple interest method. Compounding takes into account the fact that $5,300 is the balance at 6 months, and therefore, the amount of interest earned is not $300, but more since instead of calculating based on $5,000, the interest is calculated on the new amount, $5,300.
Compound interest uses the same variables as simple interest, but we also need to know the frequency of compounding:
The balance of the loan or savings account (P)
The annual nominal interest rate (i)
The time in years (t)
The frequency of compounding in one year (n)
The compound interest formula is:
The formula differs from simple interest in one major way which is interest is compounded on top of what's already paid. The exponent takes care of compounding by multiplying n times each year by the number of years, which turns into the total number of periods.
Consider a $5,000 savings account with a 12% simple interest rate; interest is paid semi-annually, but this time use the compound interest method.
What is the account balance in one year? For the first half of the year, no interest has been paid, so the compound method is the same as the simple method. The balance grows in half a year to:
$5,300 = $5,000 x (1 + .12 * .5)
Now comes the interesting part. For the second half of the year, interest is computed on top of the interest that's already accumulated. Interest is therefore computed using a $5,300 balance (instead of a $5,000 balance in the simple interest case). This is what differentiates compound interest from simple interest. After one year, the ending balance is:
$5,618 = $5,300 x (1 + .12 * .5)
The result is slightly higher than the $5,600 from the simple interest method. To calculate it in one calculation we would use the formula we showed at the beginning.