This is a great rule of thumb: "a 1% increase in prevailing interest rates decreases the value of the loan by approximately 1% per year of duration".
Especially good to keep in mind for borrowers who are trying to negotiate payoff amounts for fixed term loans. A 5% interest rate increase means you can potentially negotiate a loan payoff for significantly less than you owe for loans that have multiple years remaining. Has anyone been successful at this for consumer loans recently?
Yeah, I've thought there should be a cash-out mortgage refinancing product for monetizing the difference between my 2.5% mortgage and prevailing rates north of 5%. Unfortunately, I don't think there is.
In Denmark this is a standard feature of fixed-rate mortgages.
The rate for fixed rate mortgages is now around 4-5% p.a. If you had taken out a 30-year fixed rate mortgage for $100k when rates were around 1%, you can now prepay it for just $70k, i.e., at around a 30% discount.
Another interesting feature is that the mortgage can stay with the property when it is sold (subject to the lender approving the new owner). This means that the current economic value of the mortgage can be factored into the purchase price.
> If you had taken out a 30-year fixed rate mortgage for $100k when rates were around 1%, you can now prepay it for just $70k, i.e., at around a 30% discount.
This isn't optimal money management. If you have a loan at below market rates, pay it off as slow as possible. Instead of using $70k to pay it off, invest the $70k in something that pays more than the 1%. You'll monetarily be much better off.
In other words, borrow money at a lower interest rate, and invest it at a higher interest rate. You make money on the difference.
A friend of mine who I helped coach through financing his car, did just that. The interest rate at the time was the market rate, and I advised him to accelerate his car payments. But interest rates have risen so much, I advised him to switch to making minimum payments. He caught on quick :-)
If it is at market rate, the two options have the same value. Now if you have options on the payment schedule, that makes it more complex to value, as there is additional optionality. But the fundamental pricing of fixed incomes securities is such that the discount is exactly the same value as the value of paying off slower.
Yeah, I just stopped paying the „Sondertilgung“ (special repayment) for my 1,66% loan, and instead put it into a fixed deposit account at 3,25% (compounding).
> If you had taken out a 30-year fixed rate mortgage for $100k when rates were around 1%, you can now prepay it for just $70k, i.e., at around a 30% discount.
Maybe this is a dumb question, but could you finance the prepayment with a new mortgage?
Yes, but factor interest rates in. Refinancing 70k at 5% is worse than having 100k at 1%. So although it may be doable, I don’t imagine seeing this in practice
No -- if the discounted prepayment is the market price, they should be more or less exactly the same. That's why you get the cash out (100k - 70k => 30k, for example).
I'm pretty sure that consumer lenders will never negotiate with borrowers to allow paying off a loan in good standing for less than the balance. Usually they're only willing to negotiate if you're already in default, and your credit rating will take a hit either way. In many cases the loan will have already been securitized and sold to an outside investor so the servicer that you deal with might not even have the contractual authority to negotiate with you.
This is correct. The only time you will get a chance to do this with a non-commercial loan (like a massive loan on a factory, etc) is if you got a loan that was so short term that the bank didn't bother selling it, and kept it in house.
Then there is a slight chance that you can convince the bank to give you a bonus for refinancing with them.
Someone clever enough to try this might also just invest their cash in treasuries and cut out the middleman's fees, unless you think you know better than the bank that interest rates will be coming down soon and the opportunity will evaporate (banks are not great at predicting market conditions as showcased recently by SVB and company but I wouldn't do it personally without some edge).
Edit: Although if the bank was mismanaged into a bad liquidity situation, they might want to offer an even better price than the difference between treasuries would provide as incentive.
The idea came up before on HN[1], where the upshot is, banks don't do this, because if they sell the loan at all, they sell a bunch at once, and there are game-theoretic reasons not to encourage this kind of deal. But Denmark gives you the right to buy your mortgage back under that formula, meaning you benefit from interest rates going both up and down.[2]
I got a chuckle out of that... I'd be very interested in hearing if this was ever done in the history of consumer loans (from a reputable financial institution). Don't get me wrong, I've got a 4% mortgage so would totally go for some of that "reduced loan payoff" stuff, but it's not realistic.
Better: a 100 bp increase in prevailing interest rates...
edit to add:
Also, in the context of loans/notes/bonds, duration refers to sensitivity of the price of the instrument to a small change in interest rates.
Knowing the duration of the instrument is all you need, it is very odd to say 'by approximately 1% per year of duration' If the duration is 4 yrs, a 100bp increase in rates will result in a 4% decline in the price of the bond.
That is a neat idea; a calculator to plug in the numbers and get back a hypothetical payoff number. It would be also neat if we could track which lenders are willing to take the deal; it may lead to people preferentially using them in the future.
It's a great reminder that a policy of secularly low inflation is a gift to creditors at the expense of debtors. Inflation wiped out more real student debt in 2022 than the forgiveness program attempted to.
The problem is that the bank is carrying the loan on its books and pretending it has full value. Negotiating that improves their actual financial position, but requires recognizing the loss that they are trying to ignore. If the stop ignoring it then they are possibly going to fail.
That is why the banking sector badly needs such a giant bailout right now.
It's not that they are pretending it has full value. They keep (some) loans on their books valued at "to maturity" not "to market". That's perfectly reasonable.
The main problem is if they switch any loan from "to maturity" to "to market", every loan has to switch or none.
It's a units problem. Dollars today are not worth dollars tomorrow, there needs to be a conversion. You can argue about what the conversion should be, maybe mark to market isn't right for reasons, but it's a reasonable baseline guess.
If you want to estimate current dollars, and forecast dollars at the end of the month, quarter, year, etc; that's fine too, and would probably give a better picture of the books than wrong math where current and future dollars are compared directly as if they were the same.
The thing is most of the time current dollars don't matter to a bank. They get money over a long period and then pay money out to account holders over a long period as well.
Book value accounting only works if you have matching regulatory or matching duration capital for the original loan.
Mortgage banks drove the UK bankrupt cap in hand to the IMF in 73 with far far less of a rates delta than is happening now.
Edit : there was a similar breakdown of society as is happening already today almost everywhere , back in 73 in the UK. The main difference is that the banks managed to put much more of the pain onto the common man since then.
There is ample reason to believe that banks will be fine and the future will continue without random bank runs, SVB was an outlier.
But even if that happens, the delta between book value and market value for the banks is mostly covered by shareholder equity, so banks may fail but the system should be fine.
Suppose I owe you a million dollars for 30-years at a fixed rate of 5%. If the prevailing rates are 5% or less (and you think I'll remain solvent), there's no real reason for you to take less than face value if I agree to pay it off now.
Suppose then prevailing rates go up to 10%. Now you have incentive to take less than a million dollars if I pay it off now. You could take the million bucks and lend it back out at 10% now, but you're stuck with 5% with me.
The question is "how much incentive/how much less would you rationally take?"
But the bank is in the position to “create money” to loan at 10% while also making that 5% on you. I don’t think it’s realistic to expect the bank to be interested in taking your (lower) payoff specifically to loan it at a higher rate.
They still have reserve requirements, meaning the total money they can lend out isn't infinite and therefore the money they lent to me they might wish to have back and lend it out to someone else at the higher rate.
> meaning the total money they can lend out isn't infinite and therefore the money they lent to me they might wish to have back and lend it out to someone else at the higher rate.
That's assuming they have someone else to lend it out to who is not only equally creditworthy, but equally creditworthy at the higher interest rate and therefore payment amount.
By that logic you would expect banks to create infinite money and drive interest rates down to 0.00001%. the fact that doesn't happen should hint that you've misunderstood how banks work
Depends how many people come back willing to sell their loans, and what that does to the liquidity position of the bank, and their current intentions regarding investment and the capital requirements to execute that.
It doesn't matter if the bank owns it or it's packaged in an MBS. Whoever owns it would be financially inventivized to let you pay off your loan at a discount and pocket the difference in reinvesting at a higher yield.
> So I had a brief negotiation with First Republic, where I asked for (and got) a $100,000 credit line “for cash management purposes.” My recollection is that this took less than two hours total, inclusive of time to write the loan application.
Fascinating look at a world that I just kind of assumed was only for the ultra-wealthy. Who knew one could simply stroll into a bank, and two hours later and a couple of signatures and handshakes, simply walk out with a $100K unsecured line of credit! Mind blown. I always just assumed that you had to show $millions in net worth or be some kind of Investment Banking super-partner to the bank in order to get such generous treatment. Or at least secure the credit with something. Wow.
Unfortunately, your intuition is largely correct. The First Republic product was unique, and basically a marketing tool (as the article does explain). Typical unsecured rates for loans to individuals are floating, calculated as (libor/sofor) + some market rate, or maybe just prime+. The market rate can be quite high.
Depending on prevailing circumstances (basically how long has it been since there’s been a financial crisis, or how frothy are the markets currently?), it can be a pretty common product. Like Patrick wrote, smaller lenders and private bank divisions of the big banks (used to?) love to give these to people with highly probable future income and wealth generation potential (doctors, lawyers, etc.)
Though, am I wrong, or wouldn’t it be pretty straightforward for someone with what I assume would be average comp for an HN reader to take out several credit cards and get a similar amount of unsecured credit? Obviously a different loan product (higher interest rate, non-amortizing) but isn’t that a fairly accessible path to six figures of unsecured debt?
Sure one can use credit cards, but the *below market*, and *fixed* rate on *unsecured* debt is fairly unique. In fact, I don't think there is anything even remotely like it available today. But do let me know. I too gorged on that First Republic Product and I miss the good old days.
For high-net worth individuals it's pretty easy to access significantly sized pledged asset lines of credit, portfolio margin loans, and the like but that's secured debt, often (but not always) variable rate, and the rates are not great.
When interest rates were zero-ish, you could get low margin rates, but again, not fixed and secured.
Sorry for the late response - if you see this, I think Citi private bank still has some pretty cheap unsecured loan products.
Agreed, credit cards are a different beast and not as borrower favorable as those lines of credit, but probably with 10 years of responsible credit usage and a decent job could put enough on credit cards to bootstrap a startup with $0 outside equity. And there’s always the Argentina put if it doesn’t pan out.
I talked to my citi private bank rep. He was quoting ~8% rates on asset backed loans. Seemed a bad deal to me. I find that citi is a bit negotiable, so if you are getting quoted significantly better rates let me know!
There was nothing stopping Patrick from clearing out his other accounts, spending his line of credit on hookers and blow, and returning to Japan before the bank started knocking on his door.
> The fundamental purpose of bank loans is to enable measured private risk-taking by leveraging a small amount of bank equity (from risk-taking investors) with a larger amount of risk-adverse deposits. Sometimes the risks are opening a restaurant or buying an apartment building in an up-and-coming neighborhood; here the risk was a crash project to build charitable medical infrastructure during a crisis.
This is central to the author’s defence of the social importance of banks. And if only it were true, banks really don’t finance small businesses in a meaningful way anymore. At least not in the UK.
I sometimes joke that my investors in my first two software companies were Visa and Mastercard (i.e. I was actually loaned money from two large American banks) and by exit they made ~$20k in interest payments.
I’m annoyed that signature loans have almost disappeared for small businesses, but the amount of credit extended to small businesses is not small. (Particularly if one does not exclude small real estate businesses from the definition of small business.)
I have known people in the US who got 5-digit business loans to start their business. Not that they _should_ have been given those loans, mind you; restaurants are a horrifically high-flameout business in the US. But it happens.
Matt Levine (Bloomberg) has discussed recently, how it is not entirely out of the question that the basic idea of any bank "investing long-term" (i.e. loans, T-bills, etc.) with the money from short-term deposits, might be dying. The deposit money is far, far easier to pull out now, and since bank-runs are self-fulfilling prophecies...
One theory is that private equity that needs to find places to invest, will provide the cash, and banks provide the places to invest it. In other words, the taking-deposits and the providing-loans parts of banks would no longer be connected to each other. Don't know if it will actually happen that way, of course.
I'd be curious to hear @patio11's thoughts on how much the prevalence of fixed rate loans in America influences the high rate of bank failures. IIRC the USA is one of only a few developed countries to have this system (Germany is another but the housing market there is much more rental based). Most others have variable rates, so banks simply raise the rates when interest rates go up. This has other consequences, specifically for consumer ability to service those loans, but it does help stop banks from going under. To the extent there were problems in the UK and Australia for example, they were largely fixed by regulatory changes after the GFC.
I think youre slightly underestimating the prevalence of fixed term loans. While 30 years is most common to the US and nordics there are lot in the 5-10 year range globally. I vaguely recall something like 30-50% of loans being this type of fixed range globally.
Can you explain more about why fixed terms are related to bank failures? IME very very few loans are held by the issuing bank. Almost all are resold, bundled & securitized, and then resold again as long term debt. Im missing why the bank would care that someone defaults later on. Its
It’s kind of the entire thesis of the piece that marking to market of fixed rate loans in a rising interest rate environment is what made First Republic insolvent. So you should ask @patio11 that question not me.
Fixed interest rate loans do exist elsewhere but they tend to be fixed for a fairly short period relative to loan duration, and constitute a much smaller part of the book, so between the two effects you might be looking at an order of magnitude of difference between US banks and say Australian banks in terms of interest rate exposure.
And then there’s the bit where the US simply opted all its banks except the big 4 out of Basel III regulation, which is why First Republic could exist in the first place, and only exist in the US.
I'm interested "the metaphysics" of credit emission
too bad this is not publicly permitted, I fear this stuff only gets discussed in private (occulted) societies and 'back rooms' (or private lounges) with lots of wooden furniture (I imagine)
when somebody emits a credit for somebody else, they've set a requirement for the future, this has consequences that ain't so simple; and what's worse, that are all taboo to discuss with 'randos' (outsiders of any sort)
Especially good to keep in mind for borrowers who are trying to negotiate payoff amounts for fixed term loans. A 5% interest rate increase means you can potentially negotiate a loan payoff for significantly less than you owe for loans that have multiple years remaining. Has anyone been successful at this for consumer loans recently?