Digging Your Way Out of a Hole
Mar. 1st, 2004 01:30 pm![[personal profile]](https://www.dreamwidth.org/img/silk/identity/user.png){kind=small}
rowyn"You can't dig your way out of a hole". The intent behind this remark, if I understand it correctly, is "you can't get out of debt by borrowing more money".
Now, this is sound advice and I almost hate to argue with it, because so many people today are much too casual about debt anyway. Nonetheless, there is an underlying fallacy to it, and I feel the urge to poke at it on that grounds.
The simplest way to put this fallacy is this:
"All debt is for consumption, not investment".
Now, in America, most personal debt is for consumption. People use credit cards to buy dinner out, vacations, books, music, movie tickets, TV sets, etc. -- things they want to increase their happiness, but which will not increase their net worth. The things we buy are usually worth less after the purchase.
The one big exception to this in the consumer world is real estate. On the whole, real estate appreciates in value, even the home you live in. It's not a great investment from a capital-gains view, however, because it also costs money to maintain. It needs periodic repairs and has utility and tax bills attached. But a home is still a good investment, because you have to live somewhere, and owning your own home means you don't pay rent.
Now, getting back to that debt-and-hole thing.
Let's say you're $103,000 in debt for your home, which you bought 15 years ago on a 30-year loan (You owed $150k on it when you bought it -- you must've moved into a nice neighborhood). You've got 15 years left before the house is paid off, and your payments are $828 a month, at an interest rate of 5.25%.
Now, disaster strikes: you lose your job, your twelve-year old car dies, and you're living on unemployment, which only gives you $700 a month. You're rapidly running out of savings, you can't afford a new car, and you don't know how you're going to find a new job without a car.
You could sell your home and move to somewhere on a busline, but you're probably not dying to do that. Besides, relocating costs money, too, and you'll have to pay rent after you move, and you still won't have a job yet.
Or, you could get some more debt.
Your home appraises at, let's say, $150,000 (apparently, you bought during a real estate bubble. Whoops). You've got a good credit rating, so you go to a bank and get your house refinanced for $120,000, on another 30 year loan. Your interest rate goes up to 6% because hey, you're unemployed and they don't love you that much. You use $10,000 of the new loan to buy another car, and keep $7,000 in cash to pay your expenses while you look for a new job. Your total debt and your interest rate has gone up, but because you have 30 years left on the mortgage again, your payments have gone down to $720 a month. Life isn't good, but depending on what your other expenses are like, you should be able to last a year or so and (hopefully) find a new job.
Now, there are some key assumptions that make this plan look attractive. The biggest is the assumption that, with a car, you can find another job in the area that will cover your expenses. For most people/situations, that's a fairly reasonable assumption. (It's also probably not as easy as I've portrayed to refinance a home loan when you're unemployed, but let's pretend it's possible). There is risk in this plan: if you don't find another job, you'll still wind up losing your house and you'll be deeper in debt then. It would be less risky to sell the house outright, move to a smaller/less pleasant apartment that'd be cheaper, and use the remainder of the sale proceeds to buy a car and pay rent until you can find another job.
But the plan with the least risk isn't necessarily the best one. Let's say you go the less-risk route. You sell your house for $150k, pay off your loan, pay a sale commision of $9,000, and net $28k from the sale. You buy the same $10k car with the proceeds, find an apartment for $720 a month, spend $1k in moving expenses, put down $1k for rent deposit, and bank the $15,280 you've got left over. Two months later, you find a new job just as good as the one you left. But now you're living in an apartment you don't like. You decide to buy a house comparable to the $150k one you left. You break your lease and forfiet your deposit, use the remainder of the money you banked (let's say $14k) for your downpayment, and get a $136,000 loan on a new place. Now where are you? You've got a $150k house, a $10k car, and $136,000 in debt. You're also paying PMI on the new house (because you didn't have 20% to make your downpayment) so your payments are about $60 a month higher. We'll give you a better interest rate than your unemployed refinance got, at 5.25%, but your monthly payments on a 30yr loan are still going to be $810. That's almost as much as you were paying when you only had 15 years left before the loan would pay off. Bummer. You also have no savings again.
Now, if you'd been optimistic about this whole affair, you'd have the same $150k house, the same $10k car. You'd be $120k in debt on your old house and still have $5,740 in the bank from the loan proceeds, and your payments are only $720 a month.
Sometimes it does pay to be a optimist.
[For those of you not quite following along, the main reason selling the house proved to be such a huge money-losing event is the commission to the real estate agents, which is typically about 6% of the home's sale price. There are some other incidental expenses, but that's the big one.]
Now, this is sound advice and I almost hate to argue with it, because so many people today are much too casual about debt anyway. Nonetheless, there is an underlying fallacy to it, and I feel the urge to poke at it on that grounds.
The simplest way to put this fallacy is this:
"All debt is for consumption, not investment".
Now, in America, most personal debt is for consumption. People use credit cards to buy dinner out, vacations, books, music, movie tickets, TV sets, etc. -- things they want to increase their happiness, but which will not increase their net worth. The things we buy are usually worth less after the purchase.
The one big exception to this in the consumer world is real estate. On the whole, real estate appreciates in value, even the home you live in. It's not a great investment from a capital-gains view, however, because it also costs money to maintain. It needs periodic repairs and has utility and tax bills attached. But a home is still a good investment, because you have to live somewhere, and owning your own home means you don't pay rent.
Now, getting back to that debt-and-hole thing.
Let's say you're $103,000 in debt for your home, which you bought 15 years ago on a 30-year loan (You owed $150k on it when you bought it -- you must've moved into a nice neighborhood). You've got 15 years left before the house is paid off, and your payments are $828 a month, at an interest rate of 5.25%.
Now, disaster strikes: you lose your job, your twelve-year old car dies, and you're living on unemployment, which only gives you $700 a month. You're rapidly running out of savings, you can't afford a new car, and you don't know how you're going to find a new job without a car.
You could sell your home and move to somewhere on a busline, but you're probably not dying to do that. Besides, relocating costs money, too, and you'll have to pay rent after you move, and you still won't have a job yet.
Or, you could get some more debt.
Your home appraises at, let's say, $150,000 (apparently, you bought during a real estate bubble. Whoops). You've got a good credit rating, so you go to a bank and get your house refinanced for $120,000, on another 30 year loan. Your interest rate goes up to 6% because hey, you're unemployed and they don't love you that much. You use $10,000 of the new loan to buy another car, and keep $7,000 in cash to pay your expenses while you look for a new job. Your total debt and your interest rate has gone up, but because you have 30 years left on the mortgage again, your payments have gone down to $720 a month. Life isn't good, but depending on what your other expenses are like, you should be able to last a year or so and (hopefully) find a new job.
Now, there are some key assumptions that make this plan look attractive. The biggest is the assumption that, with a car, you can find another job in the area that will cover your expenses. For most people/situations, that's a fairly reasonable assumption. (It's also probably not as easy as I've portrayed to refinance a home loan when you're unemployed, but let's pretend it's possible). There is risk in this plan: if you don't find another job, you'll still wind up losing your house and you'll be deeper in debt then. It would be less risky to sell the house outright, move to a smaller/less pleasant apartment that'd be cheaper, and use the remainder of the sale proceeds to buy a car and pay rent until you can find another job.
But the plan with the least risk isn't necessarily the best one. Let's say you go the less-risk route. You sell your house for $150k, pay off your loan, pay a sale commision of $9,000, and net $28k from the sale. You buy the same $10k car with the proceeds, find an apartment for $720 a month, spend $1k in moving expenses, put down $1k for rent deposit, and bank the $15,280 you've got left over. Two months later, you find a new job just as good as the one you left. But now you're living in an apartment you don't like. You decide to buy a house comparable to the $150k one you left. You break your lease and forfiet your deposit, use the remainder of the money you banked (let's say $14k) for your downpayment, and get a $136,000 loan on a new place. Now where are you? You've got a $150k house, a $10k car, and $136,000 in debt. You're also paying PMI on the new house (because you didn't have 20% to make your downpayment) so your payments are about $60 a month higher. We'll give you a better interest rate than your unemployed refinance got, at 5.25%, but your monthly payments on a 30yr loan are still going to be $810. That's almost as much as you were paying when you only had 15 years left before the loan would pay off. Bummer. You also have no savings again.
Now, if you'd been optimistic about this whole affair, you'd have the same $150k house, the same $10k car. You'd be $120k in debt on your old house and still have $5,740 in the bank from the loan proceeds, and your payments are only $720 a month.
Sometimes it does pay to be a optimist.
[For those of you not quite following along, the main reason selling the house proved to be such a huge money-losing event is the commission to the real estate agents, which is typically about 6% of the home's sale price. There are some other incidental expenses, but that's the big one.]
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no subject
Date: 2004-03-01 01:16 pm (UTC)no subject
Date: 2004-03-01 01:20 pm (UTC)no subject
Date: 2004-03-01 01:23 pm (UTC)no subject
Date: 2004-03-02 06:34 am (UTC)Hate to nitpick, but
Date: 2004-03-01 01:25 pm (UTC)Take out a $20,000 home equity loan (or other 2nd mortgage). Even at 7%, this will have a payment of $133/month over 30 years. The extra $3,000 in cash up front compared to Rowan's example will be just about right to cover the $2,892 extra you pay in the first year by keeping your $828 payment (instead of refinancing for 30 years) and adding a $133 payment on the new loan. (This ignores the refinancing costs, which are avoided by using a home equity loan, btw, so it's actually better than it appears).
Once the immediate crisis is over, you can decide whether to be still more of an optimist and stay with a 15 year repayment schedule on the mortgage (perhaps refinancing the $20,000, or even replacing it with a car loan) or refinance everything for 30 years once your credit rating is improved by having an income and you can get a better interest rate. There are other variations on this theme like buying another low quality used car not intended to last more than a year and using a home equity line of credit as necessary to pay expenses so that you can minimize the disruption to your finances if you find work quickly.
I think that the main lesson here is to avoid paying large one time costs for reasons which might be transitory. That’s why the real estate commission makes selling the house look so bad. I just think it’s also a reason not to refinance the whole loan at a higher interest rate before knowing whether you need to take that large a step.
None of this changes Rowan's original point that there are times when you can dig your way out of the debt hole as long as you're getting something valuable in exchange for the new debt (in this case, the ability to avoid a costly sale of the house).
Re: Hate to nitpick, but
Date: 2004-03-01 03:45 pm (UTC)For example, instead of refinancing to another 30 year conventional loan, I think if the bank would let me, I'd refinance to a 5/1 ARM. You would get a much better interest rate than the 30 year conventional and your new payment would be even lower. Assuming you find a comparable job, than you could make the same size payments as you were previously, paying off more principal.
Re: Hate to nitpick, but
Date: 2004-03-02 06:14 am (UTC)My perspective
Date: 2004-03-02 06:57 am (UTC)Now that I think about it, I think I'm speaking more from my perspective than in general.
In my mindset, it really doesn't matter that interest rates are going up, because I don't think I'll live in my current residence more than 3 years.
As such, a 5/1 ARM is safe, because I plan on selling in that time frame regardless. So the lower the interest rate, the quicker it is payed off.
Now I just wish I had known about ARM's and such BEFORE closing on this house, since I have a 30 year conventional mortgage.
OTOH it is still much better, to my peace of mind, than renting.
And peace of mind trumps interest rates for me.
Re: My perspective
Date: 2004-03-02 07:45 am (UTC)And shame on your lender for not briefing you on the types of products available. Hmp! My lender quoted me a 5 yr ARM on a 30 year amortization initially, which isn't what I wanted at all. (I ended up with a 15 year fixed, which suits my needs much better).
And if you're a lot happier owning than renting, that's definitely a more important consideration than the fiddly details of which kind of mortgage you get. :)
Re: Hate to nitpick, but
Date: 2004-03-02 06:20 am (UTC)Exactly. I wasn't trying to formulate the best possible solution for this particular problem, but simply point out how more debt could be a good one. I also wanted to use an example where the interest rate on the new debt would be worse, to show that the value of the new loan to the borrower doesn't have to depend on improving the terms of the debt. Getting more debt at worse terms can still be the right choice, if your use for the money has a big enough upside.
no subject
Date: 2004-03-01 04:54 pm (UTC)Many real-estate-heavy folks debted themselves into a large amount of wealth, though not without risk.
===|==============/ Level Head
Leverage
Date: 2004-03-02 06:27 am (UTC)I am not, personally, much good at using debt as a tool, even when I know logically that it's right to do so.
Re: Leverage
Date: 2004-03-02 12:33 pm (UTC)And not only can you do it, you can teach it.
===|==============/ Level Head
Hey, Don't Argue with Me When I'm Admitting My Failings
Date: 2004-03-03 09:10 am (UTC)And all that said ... thank you for the kind words, just the same. :)
Re: Hey, Don't Argue with Me When I'm Admitting My Failings
Date: 2004-03-03 12:10 pm (UTC)This is in the riskable category. ];-)
And you're quite welcome!
===|==============/ Level Head
no subject
Date: 2004-03-02 04:53 am (UTC)And, incidentally, I had to do a bit of "investing" during my period of unemployment, even though I was in debt (for the truck and house): getting some new work clothes, driving to interviews, etc. They cost me some money, but the pay-off was worth it, I dare say.
no subject
Date: 2004-03-02 06:10 am (UTC)I think the greater point is that cheap one-liner comments make bad political theory but good news play, and shouldn't.
no subject
Date: 2004-03-02 06:28 am (UTC)no subject
Date: 2004-03-02 07:26 am (UTC)no subject
Date: 2004-03-02 07:49 am (UTC)no subject
Date: 2004-03-02 06:33 am (UTC)And I'm glad you figured out the right answers on that one! :)
no subject
Date: 2004-03-02 07:33 am (UTC)no subject
Date: 2004-03-02 07:47 am (UTC)