In the real world credit markets are imperfect and present a real-life situation of a market failure. This is due to the existence of asymmetric information and limited commitment. So, whenever you are taking credit or a loan from your financial intermediary (Nordea, OP, JP Morgan, Santander), the creditor has more information about the markets than you. As I'm dealing with credits and household loans everyday at my work, I'm going to introduce you some methods on which you can evaluate the interest and the amount of the loan that you're probably getting from a bank in this blog.
What matters the bank the most when you are taking the loan? SOLVENCY! Keep this word in your mind while you are reading this blog forward. The bank wants to know that they are getting their money back. This is why the bank can charge a different kinds of interests for doctors and office-workers. What matters is not only your current occupation and income, but also your probabilities to keep your job. As you might guess, these probabilities are better for lawyers and for doctors, for instance. If the bank sees that you possess income and capabilities that make you solvent, you get the loan with a small interest.
But where does this interest come from? How it is actually calculated? In the bank it is basically done with computer calculations on the information you have provided and you usually can negotiate the marginal a bit lower. But if we take some macroeconomic theory, the formula is quite simple:
r2 = (1 + r1 / a) - 1
where,
r2 = the rate on which the bank is going to lend you
r1 = the rate of interest that you can get from depositing your money to the bank
a = the proportion of population who are "good borrowers" (pay their money back with no delays, with 100 % certainty)
For instance, the current interest paid on Nordea's Perk Accounts is 0,05 %. If we take this as a value of r1, and we suppose that 99 % of the borrowing population are considered as good borrowers, we get that the r2 equals approximately 1 %. This means that when applying the mortgage, the expected marginal you are going to be offered is going to be 1 % on your mortgage. However, we must remember that this is considered as average, supposed that 99 % of the borrowers are solvent enough. If you are a doctor or a lawyer, the bank might offer you considerable lower marginal since you are in the top percentages of solvent customers.
It is also easy to see the effect of scoundrels who have defaulted their loans or are in trouble with their solvency. If everyone would be considered as a "good borrower", r1 equals 1 and so r2 would equal 0,05 %. That would be a very cheap interest on your mortgage.
If I have the time, it would be interested to go around banks and to test this and ask for loan offers. They probably are going to offer different marginals. Then it would be interesting to use this value to predict their value of a while comparing the interest rates in their deposit accounts. Probably a sequel for this blog is coming some day.
In real-life this might not be the case. The house itself and its location is going to also affect the amount of the marginal. Also we must not forget that banks compete fiercely against each other on who has the most solvent and satisfied customers and the most diverse portfolio in case of 2008-like mass-defaults.
What about the amount of loan that you can get? This depends on your lifetime-wealth.You have a budget constraint, which states that you cannot consume more than your current disposable income plus the amount that can be borrowed by you pledging the future value of your assets as a collateral. The bank knows this and calculates your current disposable income and asks about your collateral. For instance, if you have a lot of consumer credits that you have use to buy a car or a snowmobile and no collateral, you are already in danger to get into troubles with your solvency. Your current consumption is considered to be more than you can borrow with your assets as collateral, the bank might not give you the loan. Or will give with a high interest.
This all comes from macroeconomic theory. But what can an individual to do in practice to maximize the amount of loan and minimize the marginal? Probably the first things you should do are getting rid of excess credit cards etc that distress your solvency. Another key point is to keep our consumption within limits and as low as possible. If you have a steady full-time job, this helps also. If you are a doctor or a lawyer or studying to be one, the correct row for the jackpot is already given to you.
And the most important, keep your credit sheet clean and pay your debts! If you don't, we all are going to suffer from higher marginals that wouldn't exist in perfect credit markets.
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