The Tale of Two Tellers - Part I
We'll do a series of posts talking about a concept I created in 2007 to help consumers understand the real cost of their money - EPR (Effective Percentage Rate). The idea was simple. Each debt has a cost in the form of interest rate that measures the risk the lender is willing to price into their lending you money. In most cases the EPR is the note rate of the debt (but in some cases, mortgages may have additional tax benefits). We'll assume in this series that the main focus is on the note rate.
I researched today's rates for the 'Big 3' debts that banks provide using national averages.
Mortgage (rates today range from 5.29% - 6.865%)
Auto (rates today range from 3.65% to 15.96%)
Credit Card (rates today range from 16.9% - 21.1%)
Why a range? Credit scores and other factors impact the risk of the borrower. If you are a lowest risk borrower you could secure a 3.65% (or lower) rate when buying a car, however that same car for a high risk borrower might cost 15%. That's how the initial loan is booked from a risk perspective, and that final note rate is the EPR of that debt.
If you get a mortgage today at 5.5%, we'll assume your EPR is 5.5%. (more on this in our next post).
How do banks make a great deal of money lending? In our class, we have a lesson called 'Tale of Two Tellers' to illustrate a simple concept. If you walk up to the 'Red' deposits teller and give the teller $80,000 as a deposit for a CD (certificate of deposit) paying 2%, you have an asset at the bank, and the bank has a liability of the same amount. If you walk over to the 'Green" teller and say you want to withdraw $80,000 for an auto loan at 8%, you have a liability at the bank and the bank has an asset. You are earning 2% on your money and your are paying them 8% for their money.
In this example, if you stepped back a bit your deposits with the bank = your liabilities with the bank, but that's not how it works.
That spread is a function of the gap in the EPR - your EPR you earn is 2%, and their EPR they earn is 8%, so the 6% EPR profit goes to the bank. As an aside, they can borrow 10X on every dollar you deposit to provide new lending and use leverage to increase their returns. See how much leverage here: https://www.bankregdata.com//allHMmet.asp?met=LEV
TIP: In our example above, on this single transaction over 45 years you are a customer of the bank they'll make over $1.1M doing this again and again. You might make the deposit for your 2%, and they will lend the money to someone else at 8%, but it works the same way.
TIP: Most consumers don't understand how they can do the same thing in their lives, every day. We'll talk about that in this ongoing series.