I have a friend who is very wealthy but also a huge spender, and as a result, he’s millions of dollars in debt. Despite this, he was just approved for a loan to start a new venture. Why would a bank be okay with that?
Value of assets > value of loan
Hes cash poor but has collateral.
If he’s wealthy then he has a lot of assets which can serve as a guarantee for the creditor.
Millionaires own land, commercial buildings, mansions, villas, stocks, bonds, Lamborghinis and yachts that can be pledged as collateral. Banks love to mitigate risks with assets that are easy to liquidate.
It’s not only for rich people. There are plenty of people who are in debt because of a mortage or student loans that can get loans for other stuff like financing a car.
It’s all about how certain the bank is that they’ll get their money back. Like you said, they’re very wealthy - so it may well be that their overall wealth is still greater than the amount they owe. Lending money is profitable for the bank as long as the borrower has the means to repay it, along with interest.
This is actually how many wealthy people fund their living expenses. Their wealth is usually tied up in property and investments, and rather than selling those assets, it’s often easier to borrow money at a lower interest rate than what they’re profiting from their investments.
For example, I could pay off my mortgage if I wanted to - but I won’t, because the average yearly return from stocks is around 7%, whereas the interest on my mortgage is 4.452%. The returns from my investments outweigh the cost of my debt.
Another aspect of why it often is better is that it allows them to avoid paying taxes on sales and already accumulated profits, which is desirable because of the compound interest effect.
I think if using something as collateral for a loan would create a taxable event and eliminate this advantage, then they would care a lot less about the arbitrage play between interest rates and average long term stock returns.
The bank knows that:
- these people are able to pay it back
- it is more profitable - for the bank - to continuously lend money to them (by charging interest on the loan)
This is the same reason why some countries and companies are perpetually in debt.
some countries
all countries
