Are we looking at yet another consumer bubble?
The stock market is up, inflation is down, and although wages have not yet returned to their pre-crash levels, household incomes are beginning to gain ground. So when the Federal Reserve Bank of New York recently reported a $117 billion increase in aggregate household indebtedness, some viewed the news as a harbinger of mounting consumer confidence.
Considering the latest payment performance data for all types of consumer debt, however, I'm not so sure that's the case.
Take for instance Freddie Mac, the bailed-out funding source for mortgage loans originated by banks and thrifts. For the second time, the government-sponsored agency has directed its subcontracted servicers to be quick about modifying the mortgages it had previously restructured under the Home Affordable Modification Program. Freddie is worried that rising interest rates will compromise the loans that are due to be resetting soon. Its Fannie Mae twin is expected to follow suit.
Auto loans and student loans have also suddenly grown more unstable. According to the same FRBNY report, newly serious delinquencies—remittances that are 90 or more days past due—have markedly increased for these debt categories. Credit card defaults are on the uptick as well.
If wages are rising—albeit slowly—and inflation is increasing at about half that pace, why are consumers having trouble keeping up with the payments on their loans?
Perhaps the answer has something to do with the dark side of finance: Creative payment structuring that's used to "help" consumers get what they want (or are led to believe that they want).
Here are a couple of examples…
Did you know that the adjustable-rate mortgage was designed to save money for banks and reduce institutional risk, too? Let's start with an acknowledgment that there's no such thing as a "fixed rate" in a dynamic market.
There are, however, financial institutions that are willing to gamble on the direction in which interest rates are headed over time and price their loans accordingly. Others hedge their bets by finding partners that are willing to guarantee a longer-term rate in exchange for fees. Either way, the borrower pays extra for that financial certainty.
Variable-rate loans are typically priced at a discount to fixed-rate loans because the interest-rate risk is shifted to the borrower. In a perfect world, the difference between fixed and variable rate loans would be the value of the forgone cost of the hedge. But we don't live in a perfect world, do we?
The dark side comes into play when ARMs are used by sellers and their agents to induce otherwise reluctant purchasers to pay more for real estate than they planned. For example, a 4% fixed-rate, 30-year mortgage for $200,000 will cost $955 per month. At 3%, that same monthly payment will finance $26,475 more house—twice that amount if the mortgage is written for $400,000.
If, at a time when interest rates are at historic lows, you still need a variable-rate mortgage to make the math behind your deal work, something's wrong with your deal. The better way to go is to resist the temptation to cash-flow engineer a desired outcome with an ARM by making your fundamental decision on the basis of conventional (fixed-rate) financing. Even if you're counting on selling your home before the first reset, recent history tells us that nothing is for sure.
Extending Repayment Durations
Auto lenders have begun offering seven-year financing. But is the motivation behind these longer-term loans to improve affordability, or is it to sell a costlier product? A four-year, $20,000 car loan at 7% interest would run $479 per month. That same payment would buy $11,732 more car if the loan duration was stretched to seven years.
If you plan on owning your car until it disintegrates and don't mind paying lots of interest over a protracted period, knock yourself out. But if you intend to trade or sell that car before your loan comes to term, you could find yourself underwater, where the value of your car is worth less than the loan you'll have to pay off in order to sell it. And although you may find a dealer or lender that's willing to roll that shortfall into a new loan or lease, know that you'll only making matters tougher on yourself for the next go-round.
Look, consumers have become conditioned to using financing for their big-ticket purchases. The key is to be as hard-nosed and disciplined about negotiating loan structures as you are about the prices of what you plan on purchasing. If you can't make it work without taking undue interest rate or term (loan duration) risk, it's time to rethink your decision.
This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its affiliates.
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