Revolving debt is debt where interest is charged not only on principal (the original money loaned) but on the interest itself.
I do not like the idea of revolving debt and would support a complete ban on revolving debt. Why? I think that revolving debt sets up the wrong incentives. The basic idea of interest is that interest is a fee charged for the use of money. The borrower uses the lender's money in exchange for this fee. The charging of additional interest on accumulated interest is allowing the lender to earn additional money on money that was not theirs to begin with. This extra charge is beneficial to the lender but not the borrower for two reasons:
- The interest owed grows exponentially. Under certain fairly common circumstances, the borrower can have paid more than the original principal, but still owe much more money than originally borrowed.
- Even if the borrower defaults on the loan and never pays off more than a small portion of it, the lender can earn enough back to cover the original cost of the loan and earn considerable profit.
Revolving debt opens up the potential for a massive wealth transfer from borrower to lender. The greatest gains for the lender are in the situations where the borrower is struggling to pay off the loan and perhaps misses some payments early in the loan's lifetime, but eventually is able to pay the whole loan off or at least continue paying on it for a long time before defaulting. Lenders have the balance of power on their side to begin with, as they have the money, experience, and typically a team of analysts and legal experts. The lender not only determines the terms of the loan, but has better information and knowledge about the risks and impacts of the loan. The borrower usually only has the choice of accepting or declining the loan, and often does not have much information or experience about the true implications of taking out the loan.
Arguments in support of revolving debt:
Lenders who support revolving debt make the argument in support of this practice, that revolving debt allows them to charge lower interest rates for high-risk loans. They argue that revolving debt also makes loans available for people for whom loans would not otherwise be available.
I think that these arguments are not valid. To a lender, the purpose of lending is to earn money. But in the context of society as a whole, the purpose is to invest money into productive activities, putting money to use for good purposes.
The impact of a ban on revolving debt:
I have several predictions about the effects that a ban on revolving debt would have for society:
- By removing a large source of income for lenders who loan money to high-risk borrowers, the lenders would be forced to focus on efforts to reducing the risk of default, both by taking greater care in the lending process, and by working more closely with the borrower to prevent default on the loans.
- The total amount of debt owed by individuals to banks, in society, would probably decrease. This would be a good thing as it would represent a shift in the balance of power towards individuals, especially less wealthy ones, but also wealthier ones as well (many high-income people get stuck in the trap of revolving debt as well).
- The interest rates would rise substantially on some high-risk loans. However, this would more honestly reflect the true risk to the borrower of taking out the loan, and would encourage more responsible decisions on behalf of borrowers. Revolving debt tends to mask the true cost and risk of borrowing because the interest rates can look relatively low but become effectively higher when interpreted as a scenario in which interest is only charged on principal.
- Some people would not be able to obtain loans as easily. This is not necessarily a bad thing, as lending money to people who would squander it is not good for society.
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