Tuesday, July 18, 2017

Lending Club and Personal Credit Card Debt Crises

An astonishing number of people are mired in debt and there is no reason for this.
Lending Club is back in the news again as their disgraced former founder is also in the news, starting a new business venture.  He was asked to resign by the board of directors of Lending Club apparently for some minor malfeasance, failing to report that there were issues with some financial statements. The stock in the company has dropped to 70% of its IPO value which means it was not a very good investment for most people.

I wrote about Lending Club before and other peer-to-peer lending sites.  They were sort of a product of the tight credit era following the market crash of 2009.  Back then, few people could get loans, particularly unsecured loans, and interest rates on credit cards were skyrocketing.  In the meantime, investors were finding they were not earning much in the way of returns from traditional investments. Lending Club stepped in with a new model that connected investors directly with borrowers in a social network kind of environment.

Like so many other of these so-called disruptors in the marketplace today, they eventually have to grow up and become part of the mainstream, and that's when problems begin.  Uber and Lyft started out as ride-sharing services to allow college students to cadge a ride from friends on the way home from school.  They have morphed into an unlicensed taxi service, raising the ire of local and state regulators as well as taxi licensing commissions across the globe.

Lending Club faced similar issues. It had to file an S-1 with the SEC and position itself more as a traditional lender than as a social networking site.  And of course, eventually it did an IPO so the people who invested early on could cash out on the stock.

The problem they're having today, is that there are fewer people are desperate to borrow money - or at least fewer people with good credit scores.  There are also fewer people willing to invest in the scheme, as returns on traditional investments have improved since 2009.  The average rate of return of 6-9% on Lending Club isn't very competitive with more traditional investments which may also be far less risky.

But what struck me is interesting about Lending Club was the borrowers.  According to this Wikipedia article, the average borrower has an income of almost $75,000 a year, which is well above both the median and average income for the United States.  The average borrower has a credit score of about 700, which is below prime lending status but still somewhat respectable.

What is most fascinating to me was that the average borrower was borrowing about $15,000 and using it to pay off credit card debts.  This is a familiar story to me and to millions of others.

I've talked about personal credit card crises before, and some readers have taken me to task saying such things don't exist.  But they do, and they affect almost every American at one time in their lives or another.  Usually this occurs when we are younger and more naive about financial matters.  We get our first credit card and think that this is a sign that we are being recognized for our financial acumen.  What it is, in reality, is a well-baited trap.

The credit card companies are hoping that we will go out and spend more money than we have, not taking into account things like interest rates, payment due dates, minimum payments, and whatnot. While most of us promise to pay off the entire balance every month, very quickly this resolution goes by the wayside.  Again, according to surveys taken of individuals, 70% of people surveyed self-reported that they pay off the credit card balance every month.  According to the credit card industry which has computers which keep track of these things, 70% of people carry a balance every month.  We lie to ourselves about finances - a lot.

And credit card debt can be insidious.  The problem is, once you start using the credit card it is hard to stop using it.  The balance creeps up and you pay interest on that balance each month and it gets harder and harder to pay off the entire balance as the balance may exceed your income for that month.  You try to make a payment on the credit card, and that drains your bank account dry.  Thus in order to buy groceries and gasoline, you end up using the credit card, thus adding to the balance.  It becomes a vicious circle.

Compounding this is the way revolving credit works. When you borrow money for a car loan or a boat loan or even an unsecured personal loan, the balance on the loan always goes down over time. The interest on the loan is calculated based on the remaining balance.  Credit cards work a little differently.  If you fail to pay off the balance on your credit card, the interest on the amount owed is calculated retroactivly back to the date of purchase.

And every payment you make on the credit card balance doesn't pay off the oldest part of the debt, but rather merely reduces the monthly balance by the payment amount.  Interest keeps accruing and interest is being paid on interest.

Not only that, the interest rates can be staggering.  Most credit card sites glowingly report that a credit card has a "good" interest rate if it is "only" around 14%.  This is somewhat appalling in an era of 5% mortgages and negligible inflation.  Most credit cards have a penalty rate of 22-25% and some as high as 30%, which can be triggered if a payment is it even one day late or the minimum balance is not paid.

Once the penalty rates kick in, it could be nearly impossible to get out from underneath the credit card debt.  Again, this is something that doesn't happen with a car loan or even an unsecured personal loan.  Usually with such loans, if you're a day late with a payment you are assessed additional interest, and perhaps a late payment penalty of a few dollars.  With credit cards, it resets the entire terms of the loan and not to your advantage.

And I know all this because when I was younger I did all the same stupid things.  When I got a credit card I thought it was a sign of my financial acumen and that I was doing well.  I didn't pay much attention to the interest rate as I felt that I would "pay off the balance every month" like a responsible adult.  Of course, that didn't happen.

And back in the days of mailing in checks to pay your credit card bill, it was all too easy to have a payment arrive even one day late and kick in the penalty interest rate.  Once that happened, you were basically behind the 8-ball, with no realistic way to possibly off the debt.

Of course, the consumer would then be offered balance transfer offers from competing credit cards, which seemed like a lifeline out of the debt problem.   These were like your local pot dealer offering you heroin.  Usually these had reduced rates for a certain number of months, although usually you had to pay 4% of the balance right off the top - which is a significant amount.  The problem with balance transfers is that you pay off an entire credit card and feel that you've gotten a fresh start and fall right back into the same habits.

Debt consolidation loans and home equity loans had the same problem.  People refinance their house, take out $10,000 to $30,000 to pay off credit card debt and then start all over again running up more debt, essentially mortgaging their future to live today.

And this is why I'm a little skeptical of Lending Club and its ilk.  The people borrowing the money are going to do the same exact thing they did before.  They will borrow money, pay off their credit cards and then run up more credit card debt, leading to a risk of default of both the credit card and the Lending Club loan.  Exact numbers are hard to come by, but doesn't seem the default rate at Lending Club is all that high, although it does exist.

For the borrower, it can be a life ring thrown to prevent them from drowning.  However if they keep go on spending as they did before, it could be a life ring made of lead, pulling them to the bottom.

If you are borrowing money to pay off debts, this should be a five-alarm wake up call there something is seriously wrong with your finances.  It is a five-alarm wake up call that I have set the snooze bar on many times.  At least I had a good job and high-income and was able to do well with my real estate investments to overcome this problem eventually, and eventually became debt-free.  But when I think of all the money I wasted on interest payments - and for what?  So I wouldn't have to pay a bill for a few years?  Doubling the amount due just so I could have something today, instead of tomorrow?  Pretty idiotic when you think about it.

But for people in the middle class or particularly the lower classes, this can be a deadly cycle of perpetual debt.  Debt consolidation loans, home equity loans, or Lending Club loans just lead to more spending and more debt and eventually the borrower physically cannot pay all this debt back even if it was refinanced at a low rate.   Bankruptcy is inevitable.

And under new bankruptcy laws, much of this debt cannot be wiped out, as it was in the past.   Thus the debtor has to continue to make payments on these debts while struggling to get by with a poor credit rating.  And for many, the fun doesn't stop just there.  They then turn to shady credit lending places like Buy-Here-Pay-Here used cars, check cashing stores, payday loans, and title pawn loans to borrow even more money, at interest rates as high as 300%.

If you look at this from a mathematical point of view, you end up scratching your head.  If I make a dollar a week, and borrow more money, I end up with less wealth overall.  For every dollar I borrow I have to pay back $1.10.  In other words, if I borrow money, I don't come ahead, I end up behind.  My dollar becomes ninety cents.  If I borrow money then I will end up less wealthy and a banker becomes more wealthy.

When interest rates go up to 25-30% or more - or 300% as with some payday loans - you end up giving all of your money to bankers and keeping very little for yourselfIt becomes debt-slavery, self-induced and self-inflicted.

It is idiotic, but some of the left argue that living on minimum wage or at or near the poverty line is so difficult that borrowing money is the only way out.  However this argument makes absolutely no mathematical sense whatsoever.  Borrowing money merely makes you poorer.

As I illustrated in another posting, you can work a minimum wage job for 40 hours a week and still get by even supporting a family if you have access to food stamps and other government programs. However, if a big chunk of your income is going to pay interest on ill-conceived loans or pay back debts in bankruptcy, then your life situation is indeed going to suck.  And I suspect this is what's happening to a lot of poor people in our country.  It's not that they don't have access to money, but that they tend to squander it badly.

And increasingly, the middle class is doing the same thing, which I can speak to from personal experience.  Our generation seems to love having its toys and accessories and wants it all now and would rather pay for it later, or preferably not at all.  We've trained an entire generation to think that college should be free and student loans don't need to be paid back.  That you can go to college and have a fun time at party U. and then complain about how unfair it is that you actually have to pay for it.

And I don't disagree that it's scandalous that we are offering eighteen-year-olds obscene loan obligations on onerous terms at an age where they don't fully understand what they're signing.  But I think it's just a scandalous that we're encouraging them to do this and at the same time encouraging them to think that somehow the system is crooked and they should be given a get-out-of-jail-free card.  You sign a loan document, you are obligated to perform.  That is law as old as the hills.   For some reason it is not being taught in schools.

It took me a long time to figure this out - about 40 years in fact.  It took me a long time to figure out that the financial media and the powers that be want you to be in debt and that being debt-free and is one of the greatest things you can be in life.  It took me a long time to figure out that it wasn't an impossible to do, by wanting fewer things in life and more security, instead.

And yet this basic simple premise is shouted down by many.  Readers write to tell me that having a mortgage is a great thing because you get a tax deduction and you don't miss out on the opportunity cost of investing.  Others tell me that it's better to buy a brand new car because you get 0% interest as opposed to buying a well cared-for second-hand car.

The debt mentality is so thoroughly ingrained into our culture that it is almost impossible to shake. And if you stand up and argue that debt is a bad thing, you will be shouted down as a heretic, perhaps even crucified.

And is this Lending Club example illustrates, there are an awful lot of people - I believe an overwhelming majority - in this country who end up in these credit card debt crises at more than one point in their life.  So this is something we all experience and we're all intimately familiar with and yet we are all in vehement denial about it.

Debt is just bad, period.   Stop defending your abusers by saying that "some debts are smart" or "it's OK to be in debt, everyone is!"   These are the words of victims of battered debtor syndrome.