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Life´s Lessons (Part 2 of 2)

By Mike Minter, CFP^®

A big problem in our country is the perception of debt.

For instance, many people have told me they are worried about paying off and cancelling their credit cards because it might negatively affect their credit rating. If anything, I believe the credit rating agencies should raise your score for paying off or canceling credit cards.

Tax policy supports deductions for the interest you pay on your mortgage and second mortgages. Why? I mean I know why, but it is policies like this that make people feel they can take on more debt than they probably should.

Another issue I’ve touched on in a previous article and continue to hear over and over is that now is a good time to accrue debt since rates are so low. Well, how do they know that for sure? If you take out a loan because you don’t have or aren’t willing to sell any of your assets, then you need those assets to grow more than the interest rate over the period of that loan for it to be a good decision financially. If your collateralized assets fall during the life of the loan, then you would have been better off selling those assets instead of taking a loan.

For many, to get out of the financial burden people are facing, they will need to eliminate the debts that have accumulated in one form or another. One of my concerns is that a lot of these people could start doing it all at once which will create the complete opposite scenario I discuss in part 1 of this article. Instead of record optimism, we get continued pessimism, which has already started with protests occurring across the nation. As these movements grow and people continue to struggle, they could eventually stop paying their debts which will result in lenders wanting to get paid back sooner since they have less confidence in their borrowers. It could spread like wild fire and everyone is affected.

To some extent it is already happening. Housing is a perfect example. If you tried to buy a house five years ago when prices were high, it was no problem. Try to buy one today, even at a much lower price and getting approved has become much tougher.

On the other hand, it is still pretty easy to accumulate more debt in certain areas. Credit card applications are still being mailed by the truck load. Times must continue to be good for these companies if they can afford to pay what must be an enormous mailing expense. My sense tells me business will not be as prosperous for them at some point in the near future and when that happens, you will visibly notice getting fewer applications in the mail too.

Student Loan debt has recently grown to over $1 Trillion and many students cannot find a job. How then do these loans get paid off? Honestly, your guess is as good as mine.

What people need to remember is every time there is a default, someone or some institution is affected, and they lose money. The problem when lenders start to lose money is that they hold all the cards. The small print in those credit card agreements gives them the right to change the game or terms when they feel they need to do so. Whether that means raising interest rates or increasing monthly service payments, they will do whatever they can to get their money back while trying to maximize profitability.

When or if this occurs, not only will this mean higher debt servicing payments which means less money to spend in the economy, (not good for corporate profits or bull markets) but credit will continue to contract while unemployment remains high and wages are not increasing. This could create a deflationary environment which would make paying off credit much tougher.

The Fed thinks they can print more money to stop this from happening, but they cannot force lenders to make loans. This concept is what has taken place in Japan over the past two decades and is called a “liquidity trap.”

Bottom Line:

History has typically taught us about asset bubbles like in the stock market or housing. This time we have a debt bubble which I believe is worse. Let’s hope it doesn’t burst as it could be a very painful lesson for us all…

FYI - I know my articles haven’t been very upbeat but these are the things that concern me and it is my job to grow, and more importantly, protect our clients’ money.

Typically, as a contrarian and student of behavioral finance you might expect me to be more positive because of all the current negativity, but the problem is I still feel things could potentially get much worse than what most people expect. I also want to make it clear that long term I feel things will work themselves out and we will come back even stronger. If I didn’t feel this way, believe me, I would find another profession.

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