Debt and Taxes Ryan Guenther October 25, 2007 permalink

If there's one lesson to be learned from the sub-prime mortgage debacle in the US it's that things which appear too good to be true, are. If there's a second lesson, it's that everyone from the baby boomers on loves debt the way a battered wife loves her abusive husband. They may not understand it, it may not make them happy, but they keep going back (and hiding the bruises with expensive clothes and SUVs so the neighbours won't know).

The Canadian Federal Government recently announced that its budget surplus for 2006-2007 was considerably higher than anticipated, $9.1 billion instead of the $1.9 billion forecast at the beginning of the fiscal year. The surplus was used to pay down the national debt, which now stands at just over $500 billion. As any financial planner will tell you, the first step toward financial independence is to pay off your debt.

It came as a surprise, to me at least, when there was a huge public outcry against using the money to pay down the debt. Spend it on health care, give it to municipal governments or cut taxes, but don't just "waste" it on debt.

This really opened my eyes; people aren't getting into debt simply by being bad with money, they fundamentally don't understand it. It's one thing to get an unexpected bonus and blow it on toys (been there, done that, got the scar)—that's just poor impulse control. It's another thing entirely to counsel others to exercise poor impulse control.

Obviously there is still some self-interest at play. There's a lot of "just give the money to me" among the suggestions of what to do with the money, especially from the perennially myopic Torontonians. But underlying all of it is a sense that paying down debt, and by extension being out of debt, is not desirable. The old wisdom of saving during good years so you can survive the lean years seems to have been completely forgotten. The new mantra is: as long as you can afford the monthly payments today, who cares about tomorrow?

Which is why I think the average (wo)man-on-the-street does not understand money. Period. The litmus test being: are you following the One-Step Guide to Becoming Rich, or the related but unwritten Guide to Becoming Poor?

Understanding money means understanding compounding. When you save it works for you, when you borrow it works against you. When you do both it's like a tug-of-war and the highest rate wins. You would expect people who understand this to get compounding working for them instead of against them, which is a fancy way of saying save.

Therefore, when the average debt-to-income ratio spikes over 100% it means that people don't understand money. Overall, people are getting further behind faster than ever before. They're taking out bigger car loans, ringing up more credit card bills and, perhaps most worrying of all, borrowing against their homes.

Prior to the Great Depression, mortgages were typically very short and for a small percentage of the purchase price—an 80/20 mortgage in those days meant an 80% down payment and a five-year term. Over time, largely thanks to the Baby Boomers, down payments have gotten smaller, mortgages have gotten bigger and terms have gotten longer. Today, thanks to zero-down 40-year mortgages, refinancing and HELOCs (never mind negative amortization loans) a lot of "home owners" are really just renting from the bank.

As they continue to borrow against their home rather than paying it off, it becomes less likely they will ever pay it off. A 60-year-old Boomer refinancing into a mortgage longer than ten years (and believe me, they're out there) is a sure sign that it's possible to go your whole life without learning a damn thing.