Wednesday, October 14, 2015

Debt Advice From a Bank


A lender will always tell you that having debt is a good thing.  But even lenders realize that too much debt isn't in their best interests - or shouldn't be, anyway.


As I have noted time and time again, one reason our generation is in so much financial trouble is that the financial rules have been changed, and no one seems to have noticed.  I am in an RV park in New Orleans, next to some very expensive motorhomes.  The people who "own" them (or "owe" on them) all have pension plans and are retired, so they have cash (or so they think) to make the monthly payments.  Of course, as I have noted before, it is still easy to get upside-down on these things and end up in real trouble.

For our generation - the 401(k) generation - life is different.  Struggling to save up $500,000 or $1,000,000 to fund our retirement means that buying $500,000 motor coaches is simply out of the question, no matter how many years it is financed over.  The rules were changed - in 1978 - and no one really noticed.   Most folks just assume that retirement will just work out somehow, and that debts will get paid off.

The second change is how debt is being used with our generation to intentionally ruin people.   We loan enormous sums of money these days, often to very young people who have little or no experience with debt, credit cards, banks, and whatnot.  And since bankruptcy laws have been changed (and things like student loans survive bankruptcy) a bank can make more money by ruining a customer financially than they can by doing business with them in the normal way.

You lend money to a customer (usually through a credit card) and let them get in "over their head".   They struggle to pay off the balance at 20% interest rates (or higher) and when you've given them just enough rope to hang themselves, you swoop in and offer to refinance their house and roll over the debt.   Wash.  Rinse.  Repeat.   After three or four refinancings, the consumer has racked up tens of thousands of dollars (or hundreds) in additional debt, all of which will eventually have to be paid off.

And if the consumer decides to declare bankruptcy, well, you've got him there.   You've collected several percentage points on each sale from the merchants - more than enough to cover your overhead.   And you've collected more in interest than the principal amounts of the purchases.   In bankruptcy, often the debt is "worked out" to the point where you get most of your principal back.

The banks fall all over each other trying to lend the consumer money, and the bank that holds back and says, "Gee, maybe this guy is already saddled with enough debt!" ends up losing out.   You want to be  the bank that piles it on, not the one that lends responsibly.

Banks make money by lending money.   They don't make money from you cashing your paycheck or using the ATM.   So they want you to borrow.

Bank Of America, as I have noted before, offers some pretty self-serving advice on their website, with regard to debt.   One animated slide show begins with the premise that "everyone has debt, right?" and then goes downhill from there, ending up in the cement mixer of a consolidation loan.

(And since I don't borrow money from Bank of America anymore - no more BoA credit cards, no BoA mortgages - they really don't want me as a customer.   And that might explain why they decided to "freeze" my account while I was freezing my ass off on the side of a mountain in Alberta).

This latest advice from BoA is interesting.   Once again, we are fed the normative cue that "everyone has debt."   But they do qualify this, pointing out that any debt should also be accompanied by a plan to pay it off.  Sadly, the "plan to pay it off" for most people is based on selling their home to pay off their perpetual mortgage, which is refinanced with regularity.   And if the home value goes down, this ends up being a rotten plan.

They also provide a formula for debt - based on income.   Total debt payments divided by income should not exceed 30%.   If you are in the mortgage business, this debt-to-income ratio should be familiar to you.   Unfortunately, in the go-go 2000's, leading up to the bubble, lenders stopped checking this ratio, simply by allowing buyers to make up numbers on so-called "liar's loans".    They also offered funny-money mortgages with low initial payments, so that the debt-to-income ratio still looked healthy.

It is "normal" to spend nearly 1/3 of your income servicing debt?   It is a good question to ask, and I am not sure a bank - which is in the business of lending money - is the place to go to for the answer.  Given that for the first ten years of a mortgage, most of the payment is interest, this means that 1/3 of your income goes to paying interest to banks.   A sweet deal for the bank, to be sure.

And if you serial refinance your home, you never end up on the tail end of a mortgage, where most of the payments are principal.   So obviously, the banks love it if you keep resetting that mortgage clock to 30 years.

The accompanying .pdf article does provide some insights.  However, while they talk about "good debt versus bad debt" they predicate this on the idea that a home equity line of credit (which is what they are selling) is good debt.   And as I have outlined above, this is not always the case.   If you keep borrowing against your home, you never pay it off, and you pay nothing but interest to a bank.

Compounding this is that the IRS generally only allows deductions for purchase money mortgages - the amount you borrowed up to the purchase price of the home.   Many folks deduct interest from second or third mortgages, home equity lines of credit, or refinances, far above the purchase price of the home.

Home Equity Lines of Credit - mentioned in the first paragraph in the "good debt, bad debt" section of the article - are especially dangerous for the consumer, as they are very tempting.   You get a little checkbook and you can write checks that basically sell off little bits of your house to the bank over time.   Once you have this checkbook, you find yourself using it to pay off a credit card bill, or go on vacation, or whatever.   And like little mice or termites nibbling away at your home, you wake up one day to find you don't own your home at all.

So, no, I don't buy the "good debt, bad debt" argument.  There is bad debt and worse debt.  The best debt is none at all - debt-free.   There are no good debts.   You cannot deduct your way to wealth.

The article, I'm afraid, is less than helpful.  The "five strategies" listed amount to little more than "hey, get your shit together and do this!"   And like with diet plans and other schemes, these "willpower" deals often end up failing outright, leaving the victim feeling worse about themselves - which they ameliorate with a chocolate donuts or another round of refinancing.

The article is interesting in that is mentions Home Equity Lines of Credit several times (I wonder what they are selling here?) and although they talk about debt-to-income ratios of 30%, they even go so far as to say that 40% might be acceptable.   Imagine that, 40% of your income going to the bank.   Another 40% goes to taxes.  You end up living on 20% and wonder why you are living "paycheck to paycheck".

One of the suggestions that is not emphasized enough is "eliminating hidden expenses".   Actually, this should read "eliminate unhidden expenses".   People go into debt not to buy a loaf of bread for a starving baby, but to pay for cable TV, a smart phone, and a new car.  The cause of your debt problems is not hidden, but sitting in your driveway, hanging on the wall of your living room, or buzzing in your pocket with yet another compelling text message.    Or it may be hanging in your closet, in your "man cave" or your must-have gourmet kitchen.  Or it may be in the expanding waistline fueled by too many restaurant meals.

What gets us into debt is wanting things and one sure way to not get into debt in the first place is to want less, consume less, and spend less.   And no, this isn't easy to do, particularly if you are the kind of person who is easily impressed by flashy gadgets or wants to keep up with the Joneses.

The key question asked by the article is whether you should invest while in debt.   They sort of give a muddled answer here.   Yea, they say, pay off those high interest credit cards (with our Home Equity Line of Credit!  You're a financial genius!) and then invest for a "rainy day" (and it is about to shitstorm big time, my friend).  And of course, Merrill will be happy to take your money and invest it for you!

Sadly, what ends up happening for a lot of consumers is that they will read this article, take out a home equity loan to pay off high-interest debts (credit cards, etc.) and then use the additional cash-flow to "invest" with Merrill.   A good plan, perhaps, except what they are really doing is taking more equity out of their house and giving it to the bank.   And of course, the bank will reward them paying off their credit cards by increasing their limits to $20,000 per card - or more.

And since they think they are financial geniuses, they will rack up more credit card debt.  Wash.  Rinse.  Repeat.

And I know this, as I fell for this sort of "financial advice" from banks, two decades ago.   I kept racking up more and more debt, as I bought more and more "stuff" in my life - convinced that since my debt-to-income ratio was 30% (on paper) that I was doing OK..

But income can and will drop over time - often unexpectedly.   Where does that leave the consumer?   With some pitiful amount of "rainy day" savings in a Merrill account?    Money invested that perhaps also has declined in value?   This is not some far-fetched scenario, but exactly what happened in 2009.

Paying off debt is an investment.   If you have a debt at 5% interest, and you pay off that debt, it is akin to making 5% or so on a CD.   The interest I don't pay on a mortgage "earns" me well over $18,000 a year at this point.   That is how much I would have been paying in interest if I decided I wanted to keep that "good debt".

And it is a secured investment, too.  The home will never be worth less than the mortgage balance, as there is no mortgage.  Unless I fail to pay taxes or a hurricane washes it away, it is something I own completely.  It is safer, arguably, than a government bond.

Now of course, this is easy to say, once you are debt-free.  Getting from point A to point B is the hard part.   For me, it meant selling cars, boats, a vacation home, and a lot of other stuff I had accumulated over the years and was paying interest on (all folded into "good debt" mortgages, of course).

It also mean cutting those "hidden" (and not-so-hidden) expenses to the bone.  No smart phone.  No cable TV.  No fancy car.  No using restaurants as a kitchen.    Once I learned to live on less, well, it made things a lot simpler.

Getting back to the RV park, the folks in the $500,000 motorhome next to us make condescending remarks about our $8000 trailer (well, it was $8000 when we bought it ten years ago).   But it is paid-for, and the retired couple is making payments on their motorcoach, which in a few years will need eight new tires at $1000 apiece, as well as ten new batteries (!!!).

And it may very well be that they have made a huge financial mistake and don't realize it yet, because they borrowed a lot of money, amortized over a long period of time, on an asset that is depreciating faster than the loan balance.  In other words, they are broke, but don't realize it yet, because they bought bling on time - and have yet to pay the piper.

And that is the evil nature of debt.  It can make you feel wealthy for the time being, as you have a new car, a new boat, or a fancy house.  But over time, you are literally mortgaging your future to have things in the here-and-now.  The future you will have to pay for these things.  Best not to burden him, if you can.

Myself, I'd rather have that $300,000 or more spent on a motorhome in the bank, earning dividends and interest and paying me - rather than me paying it. 

But the motorhome is just a metaphor for whatever it is in your life you may have chained yourself to with debt - the granite countertops or the luxury SUV.   Fleeting things that really provide little in the way of real satisfaction in life, but end up consuming your life, in the form of perpetual monthly payments.

Good Debt.  Bad Debt.  No Debt.   Only one of these provides real financial freedom.

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