Thursday, 15 December 2011

The flawed system

Over the last couple of days, there has been increasing noise about the household debt levels. Apparently, Canadian household debt levels are at the same levels seen in the US just prior to the 2008 recession. Everyone is saying that we need to reduce debt. The Finance Minister, the Bank of Canada Governor, the C.D. Howe Institute ... the list goes on.

So why is it then that we have such liberal credit policies in place?

The interest rates are at amazingly low levels which in turn means that mortgage rates are low as well.

Banks will lend you all kinds of money ... and you don't even need to ask. You sir, are pre-approved for $$$ in Line of Credit, in addition to all the $$$ we are giving you to buy your next house.

Credit card companies are literally tripping over each other trying to get people to sign up for credit cards. And as soon you get one, you're bombarded with an endless supply of "cheques" so that you can max out that credit limit. Its ok if you can't pay off that money coz that only means that the companies will collect some hard-earned interest at 20%.

You can't go to any store today and expect to complete your purchase without being offered their store credit card. "Oh you already have a credit card?? Well ours is nicer. We give you extra $$ in bonus cash. Plus ours is made from the best plastic ever. Its so nice that you won't even know its there ... till the bill shows up."

Looking to buy a used beater car? "Why not go for this brand-new top-of-the-line luxury model that warms and caresses your butt as you juggle your coffee and cigarette and "handsfree" cell phone and eye-liner (wait! that's a separate rant:)). Can't afford it, well we've got just the deal for you. Since you can't afford the car, we'll give you money and the car."

And then the customer is to blame. If the "system" thinks that credit is too "free" ... well "unfree" it. About a decade ago, one needed atleast 5% down to buy a home and the longest amortization available was 25 years. I was shocked when I found out that you could now get one for 0 down and have amortization periods as high as 35 years. A lot of people don't have careers that long. How can anyone in their right mind expect them to pay off their mortgage?

I know there are a lot of people who will hate me for this. But this is what my common sense tells me ...

1. If you cannot show any discipline and save a measly 5 percent of the purchase price of the home you want to buy, you should not be allowed to buy a home.
- Yes some will argue that if they can pay their rent consistently, they'll be able to make their mortgage payments. While that is valid, its not fair to compare rental payments to mortgage payments. Add property taxes, condo fees, snow removal contract fees, hydro, gas and water bills, higher property insurance and a few others that I may be missing. Most people do not factor these costs when deciding between renting and buying. The 5% down is kind of a good faith payment, that shows that you are capable of some sort of savings. Even if you have a big enough income ... if you spend it all, becoming a home owner isn't going to help the situation.

2. If you do not expect to pay off the home in 25 years, you should not buy the home.
- 25 years is a long long time. At a 5% interest rate, on a $200K mortgage, if you just keep making the minimum required payments and the interest remains the same for the full 25 years, you will have paid almost $150K in interest on top of your mortgage amount. This will look even worse when you consider higher interest rates and higher amortization periods. Any appreciation in property will quite likely be wiped out by the interest costs. And then there is inflation and the other costs I mentioned above and very quickly its clear that you are not really ahead relative to if you were renting. Most people overlook the interest costs. And ofcourse the Banks don't want to talk about it ... its what they're after. If you start worrying about interest ... they wont get anything.

3. For 2nd and 3rd and 4th and subsequent properties, the down payment requirements need to be much higher ... perhaps even as high as 50%.
- These "investment" properties tend to mess with the real estate market a lot in my opinion. And if the market drops ... these are the first ones that get off loaded. A family that lives in the home that they own is less likely to walk away from it if its value drops. On the other hand, an investor will see it simply from a profit / loss perspective and would much rather "cut his losses". By making the down payment requirements higher for investment properties, the risk is shared a bit more evenly between the bank and the investor. It will allow fewer speculators in the market and thus perhaps avoid bubbles.

Will the "system" wake up and do the right thing? Time will tell ...

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