Truth In Lending

Consumer loans: Beyond the buzz

Just as it’s important to identify what is referred to as myths about home ownership (as is done in “On Investing Part 14”), it is important to identify myths about credit. It’s important for the same reason: believing in myths about credit can result in mistakes that are harmful (as harmful as those discussed in the second and third posting in “On Investing Part 14”). In fact, myths about credit lurk behind the mistakes people make when managing the leverage associated with purchasing a home.

Well, they aren’t the seven deadly sins, but there are seven hurtful myths. Not deadly, but the damage they do is real at both the personal and social level.

First, let’s look at the silliest myth: We are going to have a Consumer Financial Protection Agency. The Federal Government is going to run it. Whoopee! We’re all protected; it’s safe to become those passive, borrowing vehicles Government and Wall Street so want us to be. Ever note that vehicle and victim could be interchanged in that sentence and it still fits? Don’t kid yourself; it’s still your future you’re betting.

We’ve all seen what a wonderful job of managing its finances the Federal Government has done. Yep, let’s all look to them for guidance. Please give me the wisdom not to manage my finances as badly as the people who want to protect them do. Egad, they have the power to tax and enforce the taxes with guns and jail time. Yet, they still messed it up. So, let’s figure out what we can and let Big Brother protect something else. If “take your credit and shove it” is sometimes a rational response to lenders (as in “Whose Future Is It?”), “take your protection and shove it” sure sounds like something to consider.

Second, let’s address the most common myth. It’s the simplest. Many people believe that one can make oneself better off by borrowing. The truth is just the opposite when the borrowing is for consumption. If it’s for consumption, it doesn’t change income. Thus, with income the same and a debt to pay off, the borrower has succeeded in reducing his or her free cash flow. That is close enough to less-well-off to be interchangeable.

In fact, without an increase in income or a drop in what one wants, borrowing for consumption ALWAYS results in using money on items of less value. The reason is that with less income after debt service and the same wants, a smaller portion of those wants can be satisfied. Economists would say the person has to shift to a lower utility curve. In English we’d say the person now has to do without in order to adjust to having less money.

Third, to The Hedged Economist, one myth seems most tragic. It’s not the most common, but it involves otherwise financially sophisticated people. It is because it involves sophisticated individuals that it seems so tragic. Many people apply principals developed for investing to consumption decisions. They are totally inappropriate, and in most cases, wrong when applied to consumption.

For example, present value relationships are appropriate for investing. They do not apply to consumption. A dollar today can be invested with the result that it’s worth more than a dollar paid a year from now. However, there is no guarantee that a dollar spent today will result in more satisfaction, happiness, benefit, or whatever you chose to call it, than the dollar spent a year from now. If a year from now it’s a medical treatment for a potentially life threatening condition that is in question, the treatment has a pretty big benefit to most people: It would be rare to have whatever was bought be worth more than the treatment. But, it’s worse: absent the medical condition, one could still buy whatever it was that one borrowed in order to buy. Thus, what’s relevant isn’t having whatever was bought; it’s only having it a year earlier that counts.

Fourth, we need to note a myth that relates to the myth discussed above. If we don’t, the economist in me would explode. It relates more directly to an old economist favorite than do the other myths. It’s opportunity cost. There’s a double whammy associated with borrowing for consumption: in addition to the costs outlined above, there’s a cost associated with using one’s borrowing power. Think of it this way: by borrowing for consumption, one eliminates the possibility to use that borrowing power to invest.

Not only are they wrong to apply present value to the consumption, they are actually turning it on its head. The current consumption is not only probably worth less, the proper future consumption that it should be compared to is greater by the return the borrowed capital could generate.

Fifth, there’s one myth many advertisements try to conceal. Zero down and no interest for X time period is an effort to promote the idea that a consumer loan can be costless. It’s a lie. Note that nothing said so far makes any reference to the interest paid on consumer loans. Interest is a major drawback of consumer loans, but it’s not the only cost. The costs listed in connection with the myths discussed previously are above and beyond interest charges. Further, the zero down zero due for X time period is a shell game. The cost of capital to the lender is, on average, recaptured somewhere in the transaction.

Sixth, this myth concerns consumer credit rating agencies (TransUnion, Experian, Equifax), and credit scores like a FICO score. Nothing sounds more ridiculous than someone saying: “It’s safe for me to borrow. My credit score is pretty high.” It’s like always driving at top speed and saying that it’s safe to exceed the speed limit because your car can go that fast. Neither credit scores nor a car’s top speed are designed for that purpose.

One of the negative consequences of the Government’s requirement that consumer credit agencies make their files available to the public was that the public misinterpreted why the Government took the action. The public didn’t realize it was done in order to improve the accuracy of the histories. It never changed the fact that credit histories are designed to be of benefit to lenders, not borrowers. It’s classic narcissism to assume credit records are for consumers’ benefit. Just as it’s folly to assume a lender is going to focus on benefits to the borrower, it’s silly to assume the lender’s agent (the credit bureau) is looking after the interest of the borrower.

The simple fact is that credit scores have as much to do with a person’s likelihood of using credit as the likelihood of his or her being able to repay. One of the major uses of credit scores is to plan marketing campaigns. What’s really scary about this myth is, to the extent repaying is considered, the credit scoring system is totally indifferent to what the borrower has to do to repay. Whether the borrower eats cat food in order to repay or sells an asset is irrelevant. In fact, someone who would eat cat food before missing a payment would probably get a decent score.

Seventh, the final myth concerns consumer loans used to buy durables. As mentioned in the last posting, “The Many Roads To Broke,” “Borrowing can take one beyond just ignoring the only truth in finance and actually, in a sense, stand it on its head.” That’s always true of borrowing for immediate consumption. It gets tricky if the consumption is going to occur over time because durables are consumed over time. That confuses people. It doesn’t matter. All of the myths discussed above still apply as do the costs they can imply.

The myth surfaces with statements like: Borrowing for durables is OK: The durable is consumed over time and thus should be paid over time. That is analogous to arguing it is good to borrow today so that you can buy food over time. It just does stand up to any test of logic. It’s consumption. The benefit is consuming it. The saying requires viewing capital only as a parking spot for the ability to consume. Capital, well used, does more: It actually creates the ability to consume by producing things (that generates income).

It also surfaces with sayings like: such loans automatically create a forced saving. No, consumption is consumption: Saving is not consuming. Again, capital, well used, creates the ability to consume by producing things. The reaction should be the same when people say they’re investing in a car, house, Ipad, or any durable. Try responding by asking whether the investment will earn enough to buy the durable from what it earns.

There’s one saying this myth generates that’s factually as well as logically suspect. It’s that one should buy it now because the price will go up. First, note that it would have to go up faster than what could be earned with the money and the interest that will have to be paid. Second, while the price could go up, generally the opposite happens. Envision buying an Ianything or a computer and leaving it in the box for a year or two. It isn’t going to fetch a higher price a year or two later. Ah, you say: technology is different. Is it? Try it with a car, a washing machine, any durable. In some rare instance it may work out, but seldom. There’s a business secret behind model changes and upgrade cycles in durables. Manufactures know they can’t reduce costs fast enough to compete with the declining value of last year’s product. So, they discontinue production and try very hard to make last year’s product obsolete.

So, durable or not, borrowing for consumption seldom is good financial management. Note the sentence says seldom; it doesn’t say “never.” If the loan amortizes much more rapidly than the durable, there is a small chance the borrowing might squeak by. But, such situations are rare enough to be ignored. (The Hedged Economist can’t think of an example other than a mortgage).

It makes more sense to save for durable purchases than to search for such a rare situation. The opportunity costs associated with the search make never borrow for consumption a good financial management principal.