Question

In a newspaper column, author Delia Ephron described a conversation with a friend who had a large balance on her credit card with an interest rate of 18 percent per year. The friend was worried about paying off the debt. Ephron was earning only 0.4 percent interest on her bank certificate of deposit (CD). She considered withdrawing the money from her \(\mathrm{CD}\) and loaning it to her friend so her friend could pay off her credit card balance: "So I was thinking that all of us earning 0.4 percent could instead loan money to our friends at 0.5 percent.... My friend would get out of debt [and] I would earn \$5 a month instead of \$4." Why don't more people use their savings to make loans rather than keep the funds in bank accounts that earn very low rates of interest?

Short answer

People tend not to lend their savings for potentially higher returns because of the risk associated with personal loans, including the potential for total loss of the loaned amount, lack of security and the absence of a legal and financial infrastructure. Financial institutions offer security, insured funds, and structured financial transactions, making them a preferred choice for most people.

Step-by-step solution

Understanding Interest Rates

Interest is the cost of borrowing money or the return for lending money. It is usually expressed as a percentage of the borrowed or loaned amount. In the given case, the friend has a credit card with an annual interest rate of 18%, Ephron earns 0.4% interest on her CD, and she proposes lending money to her friend at a 0.5% interest rate.

Evaluating the Proposal

When comparing 0.4% (bank CD interest) and 0.5% (suggested loaning interest), it seems beneficial to withdraw the money from the CD and loan it to the friend, as it would increase the monthly return from $4 to $5.

The Role of Risks and Financial Institutions

However, the reason more people don't loan their savings for higher returns involves risk. Banks provide security, insuring funds up to a certain amount. In contrast, personal loans carry the risk of default, meaning a potential total loss of the loaned amount. Moreover, financial institutions provide financial and legal infrastructure, making transactions smooth, legal, and secured, which individual lenders may not provide.

Key concepts

Financial Literacy

Financial literacy is the ability to understand and effectively apply financial skills, such as personal financial management, budgeting, and investing. It is a foundational concept that enables individuals to make informed and effective decisions with their financial resources.

For instance, in the provided exercise, understanding of interest rates, investment options, and the risks associated with various financial activities is crucial. If Delia Ephron, in her illustration, had a higher level of financial literacy, she would have been able to evaluate not only the immediate return on her investment but also the long-term implications and the risks involved in lending to a friend.

Risk vs. Reward

Financial literacy involves recognizing that higher returns often come with higher risks. In this example, while lending to a friend might offer a higher interest rate than a bank CD, it comes without the assurance that the bank provides. A financially literate person would weigh these options carefully and factor in the possibility of the friend defaulting on the loan, which could result in losing not only potential interest but also the principal amount.

Risk Management in Lending

Risk management is an essential element in lending practices, both for individuals and financial institutions. It involves identifying, assessing, and prioritizing risks followed by coordinated and economical application of resources to minimize, control, and mitigate the probability or impact of unfortunate events.

In Ephron's case, risk management would entail evaluating the creditworthiness of her friend, the likelihood of repayment, and the potential financial loss if the loan is not repaid. It's about balancing the desire to help her friend with the need for financial security.

Formal vs. Informal Lending

Formal lending institutions have systems and policies in place to manage risk, such as credit checks and loan collateral. Informal lending, like that between friends, typically doesn't involve these stringent checks and can lead to personal and financial complications. Thus, even though one might earn a bit more interest by lending privately, the associated risks often dissuade individuals from acting as personal lenders.

Role of Financial Institutions

Financial institutions serve a crucial role in an economy by facilitating a smooth function of monetary transactions. They provide a secure environment for deposits, lend money for both personal and business purposes, and offer investment products like certificates of deposit (CDs).

Their role goes beyond just offering financial products; they also act as intermediaries, pooling the resources of many savers and lending them to businesses or individuals that can use these funds productively. Inherent in their function is the management of risks, ensuring that they safeguard the interests of both depositors and borrowers.

Protection and Security

These institutions provide a layer of protection through government-backed insurance schemes, which gives depositors confidence that their money is safe. This is why despite lower interest rates, many people prefer to keep their savings in a bank rather than lend them out privately. The security and convenience offered by financial institutions are often worth more than the small increase in potential earnings from personal loans.