The
worst mistake by far is making decisions based solely on the affordability
of monthly payments, without considering how the decisions will affect the
equity in their homes. I call
this malady �payment myopia�.
Homeowner
equity is the value of the home less total mortgage debt.
It is the largest part of the total wealth of many households, and
during retirement years serves as a cushion against financial hardship.
If you neglect homeowner equity when you make financial decisions,
you neglect your financial future.
Payment
myopia is not one specific mistake but a general approach to financial
decisions that can lead to a lifetime of mistakes.
It arises out of a lifestyle focus on the present, and an
unwillingness to defer gratification.
Those afflicted want what they want now.
Consumers
who are payment myopic all their lives seldom retire with significant
wealth. The financial system
offers them numerous opportunities for short-term gratification at the
expense of the future. The
examples below apply to mortgages, but similar stories could be told about
credit cards, automobile loans and other types of credit.
Debt
Consolidation
Home owners
with substantial short-term debt usually can consolidate the debt into
their first or second mortgage. The
interest rate on the consolidation mortgage is typically lower than the
rates on the short-term debt, and the mortgage interest payments are
tax-deductible. Because of
the lower interest rate and the tax savings, total monthly payments are
reduced.
Payment
myopic consumers, however, view the reduced payments as an invitation to
assume more short-term debt, which can lead to further consolidations.
Each consolidation reduces homeowner equity, and raises the
interest rate on the next consolidation.
At higher interest rates, a larger portion of monthly mortgage
payments goes to interest, leaving less for reduction of principal.
Long
Terms
Payment
myopic consumers also select the longest term available because it results
in the lowest payment. This
is usually a 30-year mortgage. Increasingly it is a 30-year mortgage that
is interest-only for up to 10 years.
The longer
the term, the slower the growth in homeowner equity.
The higher rate on longer-term mortgages, furthermore, causes a
loss in homeowner equity growth that is larger than the savings from the
lower monthly payment.
For
example, compare a $100,000 loan at 8% for 30 years with the same loan at
7.625% for 15 years. Over the
first 5 years, a borrower selecting the 30 would save $12,202 in payments
compared to the borrower selecting the 15.
But the loan balance on the 30 would be $16,805 higher than the
balance on the 15 at the end of the period.
Low
(or No) Down Payment
Payment
myopic consumers usually are unable to save a down payment. Anywhere else
in the world, they would be permanent renters.
But in the US, they can get home mortgages without a down payment,
provided they have decent credit.
Consumers
who can�t save for a down payment prior to purchasing a house pay higher
interest rates or mortgage insurance premiums than consumers who make down
payments. This means
that their equity will grow less rapidly in the future.
Sub-Prime Loans
Payment-myopic
consumers also tend to live closer to the edge, and are more likely to pay
late and default more frequently than equity growth-minded consumers.
Nevertheless, consumers with spotty credit records can often borrow
in the sub-prime market. As
with borrowers who put nothing down, they pay a high price for their
loans, which slows down the future growth of their equity.
Financial
markets in the US offer consumers a wider range of options for incurring
debt than any other country. The
options discussed above, and many others have legitimate uses.
They provide valuable opportunities to consumers who are forced by
circumstances to be payment myopic, but later grow out of it as their
financial circumstances improve.
Unfortunately,
other consumers never outgrow their payment myopia. If they didn�t have
access to these options, they might accumulate more wealth over their
lifetimes.
But that�s
their problem. It is bad
policy to eliminate options that help many consumers because some others
abuse them.
Copyright
Jack Guttentag 2002
