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Class 4 Overview
• Debt Options
• Debt Behavior
• Subprime Crisis and Policy Discussion
• Debt and Entrepreneurship
2
Why Debt?
• Economics Reasoning– Income smoothing (Permanent Income
Hypothesis)– Liquidity
• Behavioral Reasoning– Immediate gratification– Lack of budgeting– Innumeracy– Mental accounting
3
Federally Subsidized Student Loans
• Based on need, available to students
• Interest-free while in school
• Low 4 - 5% interest rate post-graduation
5
401k
• Borrowing from yourself (up to $50k)
• Loan details may vary depending on intent (general purpose vs. housing purchase, etc)
• Interest is the opportunity cost of your retirement investments
6Source: http://www.smartmoney.com/debt/calculator/index.cfm?story=borrow401k&hpadref=1
Mortgages
• Fixed / Adjustable rate mortgages
• Negative amortization – loan payment is less than interest charged over a period
• Interest rate after taxes of ~4-5%
7
Home Line of Credit
• Revolving line of credit in which the home acts as collateral
• Limited withdrawals
• Typical interest rate of prime plus 4% - can change over time
8Source: http://www.federalreserve.gov/Pubs/equity/equity_english.htm
Credit Cards
• Free if you repay regularly
• Interest rate from 0% (teaser) to 40% with a mode of 25%
9
Pawn Shops
• Use your possessions as collateral for cash
• Loan size is ~50% the value of your possession
• Typical interest rate of 25 - 60%
10Source: Caskey and Zikmund (1990)
Rent-To-Own
• Obtain goods via a regular payment plan where the goods and payments are collateral
• Typically end up paying 2-4 times the cost
• Typical interest rate of ~230%
11Source: Zikmund, et. al (1990)
Payday Loans
• Get a 1 – 2 week advance on your salary
• Typical interest rate of 391% plus fees
12Source: www.wikipedia.org
The Mob
• Use your kneecaps as collateral
• Everything is done on the mob’s terms
• Typical interest rate is what they say it is!
13
What We’ve Learned (So Far)
15
Do you notice any special ordering of these options?
• Debt Options
Student Loans
401k
Mortgages
Hom
e Line of Credit
Credit Cards
Pawn Shops
Rent To Ow
n
Payday Loans
The Mob
Class Exercise
You are about to send $1,000 as credit card payments this month.
How much would you pay on each card?
17
Source: Ariely et al (2011)
CARD 1$800 Balance
$80 Minimum Payment12% Interest Rate
CARD 2$2,000 Balance
$200 Minimum Payment18% Interest Rate
Debt Aversion
• Average 4 yr student loan debt is only $16,700• 26% of low income students and 31% of Asians
don’t even apply• Some people tend to pay off low rate loans
faster than required, even when there are better investment opportunities available
18Sources: Burdman (2005), Cadena, et al (2006)
Excessive Debt
• Debt / income ratio closely linked with anxiety
• Average credit card debt increased 300% (in households with at least one card) between 1990 and 2002
WHY?
19Sources: Dretna (2000), Money Central at www.msn.com
Someone Else Will Do It
• Myopia & Optimism– www.savekaryn.com – Karyn started a website in 2002 to
convince individuals to donate money to help her pay off card debt
– She did so in only 20 weeks – chances are you won’t be this lucky!
20
The Wrong Type Of Debt
• Households who shifted to 401(k) debt would save 15% on annual debt payments
• Rent-to-own is used as a budgeting mechanism for risk averse consumers
• Payday loans stem from myopia, innumeracy, self-control and budgeting
21Sources: Li and Smith (2008), Zikmund, et al (1999)
What We’ve Learned (So Far)
• Debt Options
• Debt Behavior– Debt aversion– Excessive debt– Wrong type of debt– People are clueless
25
Class Discussion
Policy Discussion from Thaler & Sunstein:
Is it complexity/cheating on the part of the firm OR
Too much hope on the part of the consumer?
What should the policy be?
32
What We’ve Learned (So Far)
• Debt Options
• Debt Behavior
• Subprime Crisis and Policy Discussion
33
Issues With Current Debt Options
• Borrowing– From banks : high rates, may not qualify, rigid
constraints
– From friends / family: uncomfortable, risk of damaging the relationship, no regulation
– From 3rd parties: transaction costs
35
Issues With Current Debt Options
• Lending– To banks: very low rates
– To friends / family: damage relationships, collection is unpleasant and not regulated
– To 3rd parties: transaction costs, legal enforcement complexities
36
Virgin Money
• Mediators for borrowing and lending money between family and friends
• The company handles legal enforcement
• Also offers real estate, personal, business and student loans
37
Prosper
• Matching service, similar to online dating
• Potential borrowers and lenders post offers
• Allows for more flexibility and smaller transaction costs
38
Zopa
• UK based matching service that obviates negotiation
• You propose a loan, they rate your risk factor– Student loan = A– Business Startup = B– Pay off credit cards = D
• Zopa sets the rate for grades and acts as the middleman
39
Class Discussion
What are the merits and issues with these services / products?
Can you think of another service / product that might be useful?
40
What We’ve Learned
• Debt options
• Debt Behavior
• Subprime Crisis and Policy Discussion
• Debt and Entrepreneurship
41