Wikinvest Wire

Valuable Lessons About Debt

Tuesday, June 28, 2005

Since credit cards were first issued and automobiles were first financed, bankers and car salesman have been more than happy to assist individuals in realizing their full borrowing potential. Realizing their full potential, that is, by borrowing more money than they really should.

For young adults, perhaps living independently and with their first full-time job, this could lead to important life lessons about managing debt and living within their means. After many months or years of credit card and automobile payments, the initial thrill having long since worn off leaving only the payments, valuable lessons about borrowing too much money have often been learned - lessons that are not quickly forgotten.

When purchasing homes, on the other hand, it used to be quite difficult to take on more debt than would seem reasonable - there, the bar was set higher. Years ago, couples would walk out of their mortgage broker's office disappointed and dejected because their dreams had been thwarted by a loan officer without a heart.

These too were valuable lessons about debt.

Maybe it seemed unfair, but someone who was presumably older and wiser had determined that the dream home so coveted by the young couple was simply beyond their means. Maybe when the couple later reflected on their denied attempt to purchase their dream home, they realized that the lender probably knew best.

But, the financing of real estate purchases has changed dramatically in recent years. Now that home financing has become as easy as getting a credit card or buying a car, valuable lessons about debt learned early on, are being unlearned later in life - this is probably not a good thing.

Credit Cards

Everyone has stories of their first credit cards or a friend’s initial experience with credit cards. It is probably still fairly common for young adults to get a new VISA or MasterCard with a $1000 credit limit, immediately go out and spend the $1000, then begin paying $20 per month to service this debt. Of course the debt never seems to get paid down - but, initially at least, it is easily serviced.

After a while a new credit card would be acquired - You're Pre-Approved!

The process would then be repeated. Another $1000 in debt and another $20 debt service. Many young adults have ended up going back to their parents when this process had been repeated many more times - when the debt service rose much more rapidly than their income and the funds to service the debt began coming up short at the end of the month.

The debt service payment had been multiplying along with the number of credit cards, and was now in the hundreds of dollars per month. Then an emergency arose, and it was game-over - back to the parents, a little groveling, some stern warnings, a few promises, and problem solved.

A valuable lesson was learned.

Automobiles

The purchase of a first automobile can result in a similar learning experience. This one, however can be much more personal - the memory of the car salesman may accompany the monthly payments. Many years ago, a roommate car salesman would occasionally come home and announce, "We buried this guy!” This was invariably a reference to some poor schmuck that came in off the street, and despite his best effort to resist, ended up driving off the lot with a car that he really couldn't afford.

Apparently, there is something both magical and legal about driving the vehicle off the dealer's lot - even if the paperwork was not quite right or the loan wasn't quite approved, you just bought a car - one way or another. You've just made a multi-year commitment to repay many thousands of dollars in both principle and interest in return for that shiny new car that maybe you really can't afford.

Missing too many car payments carries serious consequences - this could be an excellent learning experience if a new car owner needs to be taught this lesson. However, most borrowers who buy more car than they should just live with the strain of seemingly never ending monthly payments until the loan is paid in full. Then they can look back and reconsider the decision that was made on that fateful day. Was it a good decision? Was it worth it?

Another lesson was learned.

[Unfortunately, automobile leases today have given many people the impression that it is completely normal to make car payments forever. Individuals who will never experience the joy of owning automobiles outright and not having any car payments - these people do not know what they are missing.]

Houses

That brings us to today's wild world of home mortgage finance and housing appreciation. If either of the above two lessons about debt were learned earlier in life, it is understandable how they may be quickly forgotten when confronted with a force as powerful as today's global real estate boom.

With lending standards relaxed and home prices rising, debt has taken on an entirely new character - monthly payments now have a much friendlier air about them. Much friendlier in that the underlying asset seems to rise in value at a rate many times the debt service payment.

That never happened with credit cards or automobiles!

If you pay $2000 per month in debt service, and the home value rises by $5000 or $10,000 during that month, and this gets repeated month after month
, and you also get a nice place to live in - this seems like an excellent kind of debt.

What lessons are there to learn here? Maybe the lesson is that more debt would be better.

But we are reminded that these are not normal times. We are living in what The Economist magazine calls "the biggest financial bubble in history" - the global real estate bubble. What happens if current trends do not continue? What happens when real estate appreciation regresses to the mean - slowly with stagnating prices or quickly with price declines?

Would there perhaps be some valuable lesson about debt to be learned at that time?

Is the entire Anglo Saxon world about to be taught a valuable lesson about debt?

4 comments:

Anonymous said...

Another great post, Tim.

David said...

Awesome post. Thanks. Greenspan needs to go. He has certianly made a mess.

Anonymous said...

While I am in full agrement that there is a massive debt bubble!
I'm surprised that debt service is only 13%? With all the new cars and 2nd homes, I would think the number would be closer to 70-80%?
Is this number wrong?

Tim said...

I asked myself the same question - I tryed to answer it here

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