Those who do not learn from history are doomed to repeat it. Have we learned from what happened in 2007 so we don’t end up there again?
If you haven’t yet watched “The Big Short”, you really should stop reading this post right now and go reserve it from your local library.
Seriously…I mean that - bookmark this page, go get it and then come back when you’re done. I’ll wait.
(cheesy elevator music…)
Oh - welcome back! What did you think?
I know, parts were confusing - I didn’t get every last detail either. We both still got the general message though, right?
There are 3 major things that this movie reinforced for me that build a foundation for good financial management in your personal life.
1. You can’t blindly trust “the experts”
Unfortunately most people in life are driven more by money than by morality. Even if it isn’t an overt decision, we’re all wired to optimize our own situation.
With that in mind, what do you think ta mortgage broker that gets paid on commission for getting people signed up is more likely to do:
- Turn someone down for a mortgage application when it’s likely the person will be stretched beyond their limit to make their payments
- To sign up as many people as possible regardless of whether they even understand what they are getting into
Remember the scene where the two smarmy mortgage brokers are talking about how they land all their mortgages?
These guys represented the worst of the worst - everything in their book was about closing deals, not about whether they were doing right by their customers.
Plenty of the people they submitted for mortgages (and that ultimately got approved) were not able to reliably make their payments over the long haul and the mortgage brokers knew that was likely from the start.
Don’t assume that a lender approving your application means that an expert has blessed your ability to make the payments. You’re responsible for understanding your financials.
If you’re getting advice from someone whose pay is dependent on you making a purchase, take what they say with a grain of salt and make sure to do your own research.
There are good brokers and other financial experts out there, but you need to be careful.
2. You need to know what you’re signing up for
If you can’t trust the experts, who can you trust?
Or, at least, you can trust yourself if you’ve done your homework.
Most people spend more time researching what they want in a new TV than considering the terms in their mortgage and understanding the difference between fixed mortgages, ARMs, and interest-only mortgages.
If you’re going to make a $200,000+ purchase (or more once you figure in interest), shouldn’t you take the time to figure out what that signature on the loan means?
You can see my thoughts on the basic math of mortgages and how understanding mortgages can save you tons here on Keep Thrifty.
I also highly recommend Khan Academy’s videos on mortgages for a great walkthrough.
The best consumer is an informed consumer.
From my personal experience, it’s incredibly satisfying to shut down a salesperson because you know the product and your options better than they do.
3. You need to consider the non-rosy possibilities
Even if you understand the theory behind your financial options in life, many people get caught up in the optimistic scenarios.
Lots of people in the early-to-mid 2000’s signed up for ARMs (Adjustable Rate Mortgages), which have a set interest rate for a short period of time and then the interest rate changes based on some formula.
When the interest rate changes, so does the payment (interest rate up = payment up; interest rate down = payment down).
Many of the people that got these mortgages assumed that they’d either be out of their house (sold and moved on to a bigger one) before the interest rate changed or that they could just refinance.
When their “fixed period” expired, most of these people saw a sharp rise in their payment as their interest rate jumped up. Unable to make these payments, some were able to sell or refinance while others were foreclosed on.
As the foreclosures came in, housing prices dropped (banks typically sell foreclosed houses at a discount as they are just trying to get back their investment).
Falling prices in the market don’t just affect the homes that were foreclosed on - they drop the overall price; who’s going to pay $200,000 for a house from you when they can buy pretty much the same one from the bank for $180,000?
As the prices drop, many people suddenly found themselves underwater in their mortgage (owed more than their house was worth) and as a result of that fun dynamic weren’t able to refinance or sell.
How does that work?
- If you owe $200,000 but your house can only sell for $180,000, there’s no way for you to sell unless you can magically come up with $20,000
- If your house is only appraised at $180,000, the bank will only refinance you for $180,000; once again, where’s your extra $20,000?
Once this happens, the scenarios start to get really difficult:
- If the interest rate has gone up, the mortgage payment goes up and there aren’t the traditional outs for people who can’t afford the higher payment (refinancing or selling)
- If you lose your job and need to move to find a new one, you’re literally not even able to move unless you can cover the difference between what you owe and what the house can sell for
Put these together and you end up with lots of people at risk of foreclosure. Foreclosure drives housing prices down as banks try to reclaim their money.
Falling housing prices put more people underwater in their mortgages and the cycle starts all over again.
Did people in the early 2000’s consider what would happen if housing prices fell? Most probably didn’t, since housing had, for a long time, been considered one of the most stable markets.
Did people with ARM’s expect interest rates to roughly double in a 5-year period? Probably not, but having your interest rates climb that much can mean your payment going up by several hundred dollars a month as well.
The “improbable” happened in 2007 and it sent many people into financial disaster.
None of this is to say that ARM’s aren’t a viable option in certain situations, but my take is this:
There’s something to be said for the certainty of a fixed mortgage - at least you know what your payment is going to be.
It’s on you
The only person you can rely on to look out for your financial well-being is you.
Keeping informed, understanding the incentives of the people telling you what to do, and considering what can go wrong before making major financial decisions is your responsibility and the best way you can protect your financial future.
That’s not to say that things can’t still go wrong, but you do have a lot of power. Use it wisely!
Got any examples where your financial awareness saved you?
Or maybe you wish you would have known something before you made a decision that went sour?
I encourage you to share them in the comments section below so others can learn from your experience.