Installment Loans Are Everywhere

Before leaving for Australia, my family had the privilege of spending a few days in Orange County, California near Disneyland. We stayed at the Marriott Suites about ten minutes from the resort. We paid $150 per night which, at the time, seemed quite reasonable. After all, the Marriott Corporation is supposed to seek a profit, but running a hotel has a lot of expenses. There are times when rooms sit empty, there is a large staff that needs to be paid, the carpets have to be replaced periodically, the pool must be maintained, the electric bill is probably obscene (especially during the summer), and the list goes on and on. All of which factors into the price. Unfortunately for the Marriott and fortunately for my family, the competition for hotels in this particular area are fierce, so the hotels do what they can to offer a good product at a reasonable price. Personally, our stay at the hotel was great and I highly recommend it.

And yet... on the other hand, if you multiplied the daily rate of the hotel across a thirty day month, the cost would exceed that of my mortgage. Given the choice, I would much rather spend the night in my house than the small, sparsely furnished hotel room in a mid upper class hotel chain. While driving around Southern California, we had a minivan (no jokes - it was a rental, I’m not buying one, not ever) that we paid $80 per day for. Again, extrapolated across a thirty day month and that would come out over three times what I pay for the luxury SUV I currently drive.

For the example of temporary accommodations and a rental car, it makes perfect sense to rent. The transaction costs and time that would go into buying and selling a condo for a couple of day’s usage seems ludicrous. It’s the same with buying and selling a car. The ease and convenience for the short term more than make up for the significantly higher costs.

Unfortunately, when it comes to longer term accommodations, we have been programmed to believe that “owning” a home is cheaper. Sure, one can rent an apartment or a house, but that would be “throwing money away on rent” and then the renter would never own the house or “build equity”. Except homeowners rarely do anyway. As house prices begin to rise throughout the country and in my adopted home of Seattle in particular, I am increasingly convinced that our entire country learned absolutely nothing from the housing bubble and its devastating fallout.

Recently, I stumbled across this article on installment loans. The article focuses on loans for poor people with rates that are usury. Yet, the same mentality is marketed to all financial classes and people take loans like this all the time and think they are being smart. From the article, an impoverished Katrina desperately needs money for a car repair and goes to World Finance. Although she has bad credit, she walks out with a loan for $207 after posting a video game system and some other junk as collateral. She agrees to make seven monthly payments of $50 for a total payout of $350. The interest rate is somewhere between 90% - 182% depending on how you factor all the fees, insurance she should not have agreed to, and other add ons.

Considering most people go out and get home loans for between 2%-6%, the rates charged by World Finance do not look anything like a mortgage. However, here is where the similarities start... Once a customer took out a loan, World Finance actively tried to get the customer to “renew the loan”, especially in the early period of the loan. Since the initial payments are mainly applied to the interest and not the principal of the loan, an early renewal would keep the annuity stream of payments coming for as long as possible. In the article, Katrina had paid off a measly $44 of the original $207 over the course of three months when she agreed to a new loan in exchange for the $44 cash out. So she got a tiny bit of cash and agreed to a new set of seven $50 monthly payments.

Really, how is this any different from “homeowners” who take out home equity loans? On a thirty year mortgage, the principal is barely touched in the first ten years. Refinancing and taking out equity simply puts the “homeowner” further into debt and restarts the loan. The money that becomes available to the “homeowner” is not earned income, it is debt that must be repaid. If the purpose of “buying” a house is to eventually pay it off so that one can live rent free in retirement, every refinance starts the loan all over again and continues indebtedness.

Sadly, for me personally, I am now forty years old. If I were to refinance my home, I would more or less throw away the nine years of payments that I have made and have to start all over again. I would be over seventy before the loan was paid in full. Even then, I will continue to owe 1% of my property’s assessed value (how this value is assessed is the subject of another rant) every year in perpetuity as well as forego the opportunity cost of what the cash could earn me if I sold the house. Those two costs, combined together, seem an awful lot like rent. Given today’s ultra low interest rate environment, the opportunity cost is probably not much, so living in a paid off house probably makes a lot more sense. However, interest rates were not always this low and probably will not be in the future. For example, the “owner” of a theoretical $500,000 house in an environment that offers 5% risk free interest is giving up $25,000 every year to live in that house on top of paying $5,000 in property tax. This theoretical “owner” is, in actuality, paying $2,500 a month to live in their own house in addition to any maintenance costs, which can be significant.

Going back to my original point about staying in a hotel and renting a car, we accept that these costs are higher than if we bought these items. However, in the case of “owning” a house over renting one, often times renting is cheaper. Much, much cheaper. Given the extreme transaction costs of buying a home including a loan origination fee (usually 1% of the loan’s value), appraisal, and escrow and combine it with the maintenance costs that build up over the course of the multiple decades it takes to pay off a mortgage including a new roof, exterior painting, and remodelling, and then finally the significant costs involved in selling a house in realtor’s fees (6% of the sale price), excise taxes (in Washington state, it is ~2% of the sale price), etc. - it is extremely difficult to make money in real estate.

What normally happens is that people leave out these extremely significant costs and then declare they made windfall profits. For example, the house I was raised in was purchased for $60,000 in 1977. It sold for $172,000 in 1996. It would be easy for my old man to claim that he made $112,000, but he didn’t. Solar panels were installed. There was a significant remodel. Expenses added up over the years. Then over ten thousand dollars disappeared during the sale of the property. The house was refinanced multiple times leading to new fees and less principal being paid off. The theoretical $112k profit was more like half of that.

What’s worse is that when people discuss said theoretical profits, they are confusing nominal gains for real gains. If nothing else is learned by reading this, please come away with the ability to tell the difference between nominal and real. A nominal gain is the dollar amount of the house going from $60k to $172k. The real gain (according to this calculator) was the value of the house in 1996 dollars going from $155,346 to $172,000. When subtracting out the cost of bank fees, refinancings, maintenance, and selling costs - the house failed to make a real gain and any perceived gain was due to inflation.

Most people would be much better off renting a home for several years and having the freedom and flexibility to walk away. For the most part, the amount paid on rent would be significantly less than a comparable mortgage payment. Even better, the renter would never pay for maintenance and not exposed to large transaction costs (although moving is not cheap). Home ownership is nothing more than an illusion as most people never pay off their mortgages before selling, incur huge transaction costs, and confuses nominal for real gains. To anyone considering buying a house, carefully consider the consequences of committing a significant chunk of your monthly income to an illiquid asset subject to enormous price swings that will come with unpredictable maintenance costs, ongoing expenses, and in all likelihood not deliver any gains in real terms. Renting offers lower costs and avoids the debt cycle and you will never have the option of continuing the installment loan program of “tapping into the home’s equity”. When factoring in property taxes and opportunity costs, no one ever “owns” a home even if the mortgage is free and clear, so unless you can be so confident that you absolutely know that you will not want to move in the next thirty years, you should probably rent. I will envy you.

Do Nothing

While I was in Australia, I caught wind of a movement known in the States only as “Lin-sanity”. As a reformed NBA hoops junkie, I try not to care about what happens in the league, but even from afar, the movement caught my attention.

For those who were caught under a rock during this time period, it began when embattled Knicks Coach Mike D’Antoni decided to put little used point guard Jeremy Lin into a game after the team squandered a fourth quarter lead against the rival Celtics the previous night. Lin responded by dropping 25 points on all star guard Deron Williams in a New York win over the New Jersey Nets. Lin followed up that performance with 28 points in a win over the Utah Jazz.

Soon Jeremy Lin would be named the Eastern Conference Player of the week after averaging 27.3 points and 8.3 assists including a 38 point performance against the Los Angeles Lakers where he outscored Kobe freaking Bryant. This all from a guy who did not receive a scholarship for college basketball and had been cut several times by several teams.

After becoming a regular part of the rotation, Lin averaged 18.5 points and 7.6 assists over 26 games. Then, sadly, a tear on the meniscus of Lin’s knee caused him to miss the remainder of the season and Lin-sanity was over just as quickly as it had begun.

Kobe’s take? In a moment of rare humility and honesty after being bested by a player who barely made the Knick’s roster:

“The biggest thing to me is how everybody missed it. They all would be fired if I was owning a team. I hear this stuff, 'It came out of nowhere.' I think it's a load of [garbage]. You can't play that well and just come out of nowhere. There has to be something there and everybody missed it. So heads would roll [if I was owner]."

The reason Jeremy Lin came out of “nowhere”? He is of Chinese descent. In a league that has been dominated by African Americans since before the signing of the Civil Rights Act, it would usually be hard to accuse owners and players of racism, and yet... Here was a player who was known to be hardworking, had a great attitude, extremely intelligent (he graduated from Harvard), showed great leadership ability when given the chance, and showed flashes of playing like an all star at times who couldn’t even get a Division I scholarship. UCLA won an NCAA title in 1995 with Ed and Charles O’Bannon and Tyus Edny, none of whom were able to make any significant impact in the NBA. Surely, there was a Division I school out there who could have used the talents of Jeremy Lin, the force behind Lin-sanity? If Lin were a black athlete would he have received a college scholarship? If he were white, would his road to the NBA been easier? Absolutely, because before Jeremy Lin no one had ever heard of an Asian making an impact in the pros (with the notable exception of Yao Ming who stood at 7’6”, with that kind of height, his ethnicity didn’t much matter).

So what she be done about this injustice? How do we ensure that future Asian athletes get the same access to scholarships and a chance at the NBA? I say do absolutely nothing. Sports, for the most part, is a meritocracy. Mr. Lin has broken the Asian race barrier and scouts are now on the lookout for the next Lin. No one wants to make the same mistake again. As Kobe said, any scout or owner who passed on Lin should be fired.

A decade ago, when discussing affirmative action, I facetiously suggested that strict race quotas be observed in the NBA. By my math, since African Americans make up only 14% of the US population; only two black players should be able to be on a team and only one on the court at any given moment. Further, there should be two Hispanics, two Caucasians, or one of the Hispanics and Caucasians could be substituted for an “Other” at any time. Of course my suggestion was absolutely ludicrous. The absolute best combination of players for each position should be on the court at all times - not some bizarre racial quota. Sadly, the extreme leftist liberal I was talking to thought my suggestion was a great idea. I walked away shaking my head.

The whole premise of affirmative action, in my humble opinion, is flawed. Universities that use it claim that having a “diverse” group of students enhances the educational environment. Of course, this “enhancement” is provided in a way that cannot be quantified or studied. Since the Left have declared it is so, then it must be correct. As a result, underperforming students are given slots directly taken from better qualified students based on their ethnicity. The difference in test scores, by race, in Universities that participate in affirmative action is startling.

In 1997, a study conducted demonstrated that Asian-Americans needed to have an SAT score 140 points higher than a white student, 270 points higher than Hispanic, and 450 points higher than a black student (out of a then 1,600 possible points). This is absolute madness! The quota system that was supposed to help minorities actually demonstrably hurt one specific minority - Asians, which brings up an interesting point, why are Asians (statistically) kicking the crap out of every other racial group?

Most of the Asians now applying to universities are immigrants or the first generation born in this country. Their parents have instilled into their children the value of education and have pushed them to excel in school. For the most part; dropping out of high school, not preparing for the SATs, not completing homework, etc. is not tolerated. The parents want a better life for their children, work hard, and demand the same of their kids. This recipe for success is a pretty good model and should be emulated. Punishing children who grew up with a culture that values education and hard work seems downright un-American. If other groups are not performing well, maybe something should be done, but it should be done much earlier and not to the detriment of those who put in years of hard work.

Supreme Court Justice John Roberts has stated, “The way to stop discrimination on the basis of race is to stop discriminating on the basis of race.” Two affirmative action cases are now heading to the Supreme Court and I sincerely hope that the hopelessly flawed program comes to an end. No one would dare consider applying it to sports, so why apply it to academia? As for Jeremy Lin, don’t feel too bad for him. At the end of last year’s season, he was acquired by the Houston Rockets with a guaranteed $30 million contract. I’m pretty sure that with the guaranteed money, a Harvard education, and a strong work ethic that he will do fine. In his first full season with the Rockets, he played inconsistently and did not live up to the hype of last year. However, he has many more years ahead of him and has a lot of potential. It is easy to forget that Steve Nash, who plays the same position, was dumped unceremoniously by the Dallas Mavericks and considered too old right before he won back-to-back league MVP awards. Regardless of whether or not Jeremy Lin becomes great or is considered an average pro, the next Asian hoops prodigy will find it easier to be accepted. No radical fix is needed.