can I make money off my low-interest loan?

November 17, 2005 7:33 PM

FinanceFilter: can I make money off my low-interest loan?

So I borrowed a bunch of money to pay for college, and at the time, interest rates here in the US were historically very low. If US interest rates continue to increase, is there any way for the lender to make money in this scenario?

For instance, I know that banks sell/buy loans to/from each other. It seems that banks would pay a premium on a low-interest loan with a variable interest rate (under the assumption they would have a higher ROI resulting from increasing interest rates).

Beyond that, it gets confusing to me. Is there a good site explaining the market of purchasing/selling both variabel and fixed rate loans? Is the loan market exclusive to banks, or can lenders get in on it as well? Many thanks.

posted by masymas to work & money (5 comments total)

I'm not entirely sure I'm following this question, but if you have a low interest credit arrangement, you could take advantage of it by sticking those funds into a higher-interest term deposit, or similar. For example, at present I've got a honeymoon deal on a line of credit, so I'll keep the money in a higher-interest cash management account until the honeymoon runs out.

Remember to factor in tax you may be required to pay on interest received (but likely won't be able to deduct on interest paid).

Is the loan market exclusive to banks, or can lenders get in on it as well?

Bank deposits, cash management accounts, term deposits, all do this - just via a financial institution.
posted by pompomtom at 8:03 PM on November 17, 2005

can I make money off my low-interest loan

No. You don't have any control (or ownership) of the loan to you (as an asset to be managed) - you either make payments, pay it off, or are in default.

Is the loan market exclusive to banks, or can lenders get in on it as well?

Part of what you're looking for is probably the word securitization. That's the bundling of a bunch of loans into a security that can be sold. Collateralized mortgage obligations (CMOs) are probably the best-known kind. These can be quite complicated, and can include variable rate slices (parts, tranches).

Basically, anyone who has money to invest can buy securitized loans. Most investors aren't interested in buying specific loans because the variability is too great (if you buy, say, ten loans of $10,000, and one goes bad, then the whole investment of $100,000 was pointless). In a securitized package, thousands of loans are pooled so that an investor is essentially buying very small pieces of many loans.
posted by WestCoaster at 9:01 PM on November 17, 2005

How does a lender lock in a profit on a fixed-rate loan? Well, in the case of home mortgages (which I know a little about,) usually the original lender sells the loan almost as soon as it's written (sometimes before, actually). A sold loan typically is "securitized," that is, its scheduled cash flows are used to fund something like a bond (I'll call it an MBS even though there are lots of other ways for this to happen) that's sold to investors. As long as rates don't move too fast, the original lender and securitizing entity make their money not long after the loan is written and the folks who purchased the MBS will receive payments -- the final MBS purchasers are the people who end up with most of the risk.

In your case, I'm not sure if you're talking about regular student loans (which when I was doing this sort of thing were securitized not that differently from home mortgages) or some other kind of loan, but many different kinds of loans get securitized or at least sold to outside investors. If your loan has been sold already, the original lender has made all its money they're going to from that loan, with the exception of a monthly servicing fee if they're still the folks you send a check to.

Chances are if it's a fixed-rate loan the original lender either securitized it or, if it kept it, entered into some kind of hedge to minimize its risk. Variable-rate loans lessen the need for hedging.

Now, for the investing part of it -- all kinds of loans do get sold but the most practical way for most of us to play the game is to invest in a mutual fund that holds asset-backed securities (which are called ABS's) -- a GNMA fund would be one way to do this in the case of home mortgages. Depending on the banking laws in your state, you might not be able to trade individual loans without jumping through all sorts of regulatory hoops. You probably wouldn't want to trade individual loans or ABS's anyway -- investing in a fund means the law of large numbers is working for you -- if you own one loan and the borrower goes bankrupt you're stuck but if you put a similar amount in an ABS fund the expectation value of default may be the same but the variance will be lower. You pay for this benefit in your management fee. Professional investors and speculators who think they can beat the market deal in individual securities and loans and avoid this marketing fee. Most of them fail (after trading expenses). As an individual your best bet is to let the pros do your trading for you by getting into a fund.

It is an understatement to say there is a degree of uncertainty in valuing ABS's; therefore the market demands a higher return than for "risk-free" securities (e.g., government bonds). The tradeoff is a higher risk (variance of returns) which means increase likelihood of a loss (despite the higher expected return) and the value of your position will probably move around more than the value of a lower-risk investment.

You can spend years learning about this stuff. Here's an article on ABS's I googled but it just scratches the surface: http://www.econlib.org/library/Enc/AssetBackedSecurities.html

In any event you'll want to consult with a reputable financial advisor (not some random schlub on metafilter like me but somebody you're paying) before you seriously consider getting into the loan market.
posted by Opposite George at 9:09 PM on November 17, 2005

Oh, one more thing -- the only real way for you to make money off your individual loan is if you have some discretion over the size of payments you make AND you can earn more in some other investment than you're paying in interest. The chances of this being true in your case are probably pretty low, but it's the same idea as using a second mortgage to pay off credit cards.

A more likely scenario: If, by chance, you've been making extra payments on your loan and are carrying a significant amount of debt at a higher interest rate, you should curtail the extra payments and use them to pay down the more expensive debt.

Finally, if you can afford to pay off your loan in full today and have no better place to invest the money (that is, an investment paying more than your loan rate) you might want to consider doing that. I'm not sure what your tax situation is so make sure you look at the after-tax picture before doing that.
posted by Opposite George at 9:25 PM on November 17, 2005

s/before doing that/before doing anything major/
posted by Opposite George at 9:35 PM on November 17, 2005