The High Price of Easy Credit

Moving up the economic ladder has always been about simple, hard work. Now, it’s also about knowing how to calculate algorithms.

That daunting reality is due to the fact that working families are awash with new opportunities to borrow enormous sums of money for everything from a house to a daily cup of coffee, now owing creditors nearly $500 billion. Trouble is households often need out-of-reach math skills to determine which of these opportunities are actually in their best financial interest.

Take homeownership debt, which accounts for $8 out of every $10 owed by households today. Just 40 years ago mortgage lenders were being accused of unfairly ignoring working class families (those earning less than 75 percent of all others). Now, low interest rates, technological advances, and yes, new products like subprime mortgages, have actually made these households the fastest growing segment. In fact, we found in a recent report that the proportion of working class families with a mortgage increased by 84 percent between 1989 and 2004, compared to just a 5 percent increase among the highest income group.

That sounds like a lot of progress up the economic ladder, right? Well, not really.

For starters, the subprime meltdown this year provided dramatic evidence that a broad share of working families bought mortgages they cannot afford. In fact, the most recent data suggest that working class homeowners are 5 times more likely to fall behind on mortgage payments compared to other homeowners.

More troubling, and less widely known, even many of these hard-working homeowners who are making timely mortgage payments would have been better off renting, according to recent research. That’s because large shares of these homeowners bought too-expensive mortgages, moved too quickly to realize any appreciation, and earned too little to qualify for the mortgage interest and property tax deductions.

Getting access to a mortgage is thus only the first in a long list of variables that need assessing before families can wisely know whether to buy a house, involving math skills that go well beyond most households.

But, it’s not just potentially wealth-building credit that is booming in working class markets and putting a premium on sophisticated math skills. Since 1989, high-cost businesses like payday lenders and pawnshops, which sell short-term loans to mostly working class families, have swelled from a few thousand establishments to over 30,000 today — twice the number of Starbucks stores — even though they charge 35 to 40 times comparable credit card rates.

At such astronomical prices it seems preposterous that anyone would buy these products. But these fees are not advertised next to cheaper alternatives, and they are usually presented to buyers as small, one-time charges. That means you have to know something about compound interest to really understand these extreme prices.

But hardworking Americans realistically don’t have enough time (or probably the inclination) to enroll in enough math classes to figure this all out.

So, what to do?

In the wake of the subprime meltdown, mortgage lenders are already tightening up lending standards, and Congress is considering doing the same.

But neither of these efforts will go very far toward addressing the bigger problem here that there are deep, systemic gaps between what working families realistically need to know about borrowing options, and what they actually do know.

Probably the best response, then, is for Congress to think through ways that working families can obtain trusted financial advice and information.

One intriguing idea is for Congress to pass a tax incentive that encourages employers to play this role. It’s in their best interest, after all, to have financially secure employees, and research has shown that employer delivered financial planning is extremely effective.

Telling people how to spend their money is difficult, but at the very least they should have as much independent advice as possible. Absent that, millions of hardworking families are going to continue to trip up, missing perhaps once in a lifetime opportunities to get ahead.