What Is The Life Cycle Hypothesis And What Does It Mean For Consolidation Loans?
Developed by Franco Modigliani and his student Richard Brumberg in the early 1950s, the Life Cycle Hypothesis (LCH) is an economic theory that attempts to describe the saving and spending habits of consumers.
The key assumption of the LCH is that most individuals seek to maintain a stable consumption level, saving when they are earning more and borrowing when their income is low.
This life cycle has implications on how lenders view prospective applicants. Here we will explore the life cycle hypothesis in more depth and how it can affect consolidation loans.
A Visual Representation
The LCH states that people want to keep their level of consumption constant throughout their life.
As seen in the graph above, people will take on more debt when they are younger, counting on the fact that they will be financially secure when they are older and more readily able to pay it off.
Essentially, they are borrowing to maintain a level of consumption. As their earnings increase, usually around their 30s and into middle age, their earnings outweigh their spending, so they begin to save, keeping their level of consumption more or less equal.
As they grow older, and approach retirement, their income levels decrease and they are willing to tap into savings or credit in order to maintain their consumption level.
The LCH can be expressed mathematically by the equation C = (W + RY)/T.
C = Consumption
W = Wealth
R = Years until retirement
Y= Yearly income
T= Estimated remaining years in an individuals life
There are several key assumptions that one can take from the Life Cycle Hypothesis, the majority of which have been covered above. To recap,
- Individuals Seek To Maintain Consumption Levels Throughout Their Life: This is the key takeaway from the LCH and premise that the theory is built on.
- Individuals Will Save When Earnings Are High: Most people do not destructively or compulsively spend when their income is greater than their expenses. Those in this situation typically save to ensure that they can maintain their consumption level in the future.
- Individuals Will Dissave When Income Is Low: When earnings decrease or one heads into retirement, people are inclined to draw from savings or use available credit to maintain their consumption levels.
What Is Consumption Smoothing?
Consumption smoothing can be best thought of as an individual's efforts to maintain a balance between spending and saving throughout the different phases of their life.
The concept assumes that the vast majority of people seek to maintain a certain standard of living and will spend and save accordingly.
Consumption smoothing refers to the changes one makes throughout their lifetime to maintain this standard.
Lenders consider this concept when looking at an applicant's loan application. Those in the early stages of their life may not have the necessary income to take on the loan, whereas adults in the saving phase of their life (the portion is which income totals more than expenses) are much more likely to be able to pay back their loans.
What This Means For Consolidation Loans
To recap, the Life Cycle Hypothesis looks at people's relationship with spending and saving insofar as it relates to their level of consumption.
The theory states that people will either save or dissave depending on their income level in an effort to maintain the same rate of consumption as they have enjoyed so far in their life.
Essentially, people save when income is high and tap into savings when income is low.
Lenders are much more likely to grant consolidation loans to applicants who are in the saving phase of their life than those who are in the dissaving phase.
Those in the latter stage present a greater risk to lenders because their desire to take on more debt may be motivated by the desire to maintain a smooth level of consumption.
Those in the saving phase, by definition, have excess income and are therefore more likely to repay their debts.
The Life Cycle Hypothesis is an important economic theory because it aims at describing how consumer spending habits change throughout different phases of their life. Lenders take these phases and spending habits into account when evaluating an individual's loan application.
Anyone looking to consolidate their debts through a consolidation loan should do so when they are in the saving phase of their life to enjoy lower rates and more preferable terms.