March 28th, 2008
Yesterday, I read an article on CNN called From $70K to food bank.
It describes a woman who was laid off in February from a job paying $70,000 a year. “Weeks later”, with bills “piling up and in need of food for her family”, she went to a food bank.
The article proceeds to talk about the subprime lending situation at great length, which is largely irrelevant to this person’s situation.
Then we learn she applied for food stamps, but was denied. There’s a quote from this person about how frustrating that was, and general “tugging at the heartstrings” trying to make us feel sorry for this woman with two children whose mother moved in to help make the house payment. It seems to me that this is a correct decision; someone that can pay a $2500 mortgage each month ought to move into an apartment before trying to leech food or money from social service agencies.
And that’s where this story gets interesting.
She has an interest-only mortgage, and is managing to pay the $2500 bill each month.
If you’re not familiar with an interest-only mortgage, here’s how it works. The bank loans you money to buy your house — say, $200,000. This is a loan, and you have to pay interest on it each month, just like a regular mortgage. But with an interest-only mortgage, you never pay off the loan. You could be making monthly payments for 30 years and still owe $200,000. In general, the only ways to “pay off” this kind of loan is to sell your house, or get a conventional mortgage that pays off the interest-only loan.
Interest-only mortgages were largely banned after the Great Depression. Prior to that time, they were how mortgages normally worked. But there are several problems with them. One is that you have to pay on them forever, even after you retire. Another is that you can’t move unless you can sell your house for at least as much as the bank financed, even if you’ve lived there for 20 years. In times of declining housing prices and unemployment, that really stinks. People often default on the loans, and from a bank’s perspective, that really stinks, too.
Interest-only mortgages are usually used by banks financing construction (we had one for a few months when we renovated our farmhouse) or other short-term projects such as professional real-estate investors that buy old houses and fix them up to sell at a profit. Except for these things, in general, they should never be used for a primary house. It’s not in the interest of the bank or the homeowner.
But since you never pay off the principal, the monthly payments can be lower. It seems likely that this woman took a knowing gamble, buying a home more expensive than she could afford, and somehow found a bank willing to finance this. Problem is, both she and the bank took a knowing risk. If she ever ran into financial difficulties, she’d have to sell the house quick. But now the house is probably worth less than the value of the mortgage, so selling it won’t remove the loan — BUT it would let her pay off a large part of the principal, reducing her monthly payments and giving her some wiggle-room to buy food and pay off the rest of it.
It seems to me that she is unwilling to own up to the calculated risk she took, and wants society to help bail her out. Don’t get me wrong; I think we need to help people that run into hard times. We need to help make sure they still have the tools they need to find a job and a place to stay. But bailing out people that take huge financial risks shouldn’t be the job of society. Let’s help them land softly, but not be enablers keeping them in a home they never could — and still can’t — afford. Fortunately, I don’t think anyone in government (or running for president) is suggesting we should.
Not only that, but her bank shouldn’t have ever made that loan. Banks should be held accountable to not sell unwise products to people that rely on them for their primary residences.
Here’s another interesting point: in just a few weeks, she had burned through her entire savings.
This, unfortunately, is a quite typical situation for many Americans. My financial planner, and I think most experts, suggest that everyone ought to have 6 months of income in liquid non-retirement assets (savings accounts, investments, etc.) in case something like a layoff happens. Very few Americans have this.
And when it comes down to it, isn’t that part of the problem? The economy thrives on consumer spending. Or, put more starkly, overconsumption. If people start saving like they ought to, and stop feeling like they’re outcasts just for not keeping up with the Joneses and buying every last gadget or the biggest house, we’d all be in better shape — but the economy wouldn’t have grown as much.
The growth it would have seen, had we all been more responsible, would have been a lot more durable and recession-proof, I think.