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Consumers need to resist attraction of financing offers

Updated: May 3, 2013 12:14PM

Originally published: October 2, 2003

How can consumers keep spending more than they’re earning? It’s happening through some very creative uses of debt. The big news this week: Consumer spending jumped 0.8 percent in August, while wages and salaries grew 0.1 percent. An advance on tax credits for parents of dependent children fattened many wallets on a one-time basis, but other families kept shopping simply by taking on more debt. Yet job losses continue to mount. It’s no wonder the American family is losing confidence in the future.

Americans are becoming experts at finagling family debt. We’ve become pros at refinancing and withdrawing equity from our homes, using floating adjustable rate mortgages that literally turn homeowners into floor traders in interest rate futures. When it comes to credit cards, even ordinary folks have managed the technique of rolling from one card to another, taking advantage of a free grace period.

Who’s to blame?

So should we blame struggling consumers for taking advantage of every opportunity that comes along to beat the system, borrow more and stay afloat? Or should those who offer these forms of creative financing accept some responsibility to at least clearly spell out the risks involved?

For example, a public relations person contacted me a few weeks ago to interview the CEO of a mortgage company that specializes in adjustable-rate mortgages, offering tips to make homes affordable to borderline borrowers.

I politely explained that I would also have to write about the potential impact of rising interest rates on those adjustable mortgages. Monthly payments could become so expensive that consumers would be forced to default, losing not only their dreams of home ownership, but the down payment they had invested. She decided not to pursue the interview for her client.

An owner of a car dealership explained that his business was making cars more “affordable” for consumers by stretching financing periods from the traditional 36 or 48 months all the way out to 84 months -- and potentially even to 96 months! Lower payments on longer loans make it easier to sell new cars.

For example, if you finance a $20,000 car for 60 months (five years), your monthly payment will be $377.42. But if you finance for 96 months (eight years), your monthly payment is only $282.73. You’ll save nearly $100 a month in payments. But you’ll pay an extra $4,500 in interest with the eight-year loan.

Yet that’s not the real problem. It’s the fact that you’ll be “upside down” -- owing more than the car is worth -- for such a long time.

In the five-year car loan, your break-even point -- where you could sell the car for the money you’ve paid into it -- is 40 months or just over three years.

But if you take the eight-year loan deal, you’re upside down for 65 months -- nearly 51/2 years. For all that time, you owe more than the car is worth! And if you want to sell sooner, you’ll wind up owing money to the bank.

But the banks used by the car dealers are cooperating by offering these long-term car loans --and they’re offering to lend up to 140 percent of value.

Now you might wonder why a new-car buyer would need a loan in excess of the value of the car. The answer is simple. Many people owe more than their current car is worth. So the only way to sell a new car is to lend enough money to cover the negative equity on the old car loan, plus cover the cost of the new car.

Question: If you lend 140 percent of the value of the new car, and the car depreciates by the typical 30 percent in the first year, what’s the true value of that loan to the bank on its books? But it sells cars.

Hot potato

When this game of hot potato stops, someone is going to get burned. And I’m suggesting that this fire will singe everyone: consumers who won’t be able to get another car, bankers who will be stuck repossessing cars worth less than the loans, and car manufacturers who won’t be able to keep their companies -- and the economy -- going by finding buyers for new cars. The game will stop eventually.

You can’t borrow your way to wealth, only to illusory economic growth. And when -- not if, but when -- interest rates start to rise again, the burden of all this creative financing will become unbearable for many families.

It’s time for the American family to get back to basics -- and to remember the great old law of holes: When you’re in a deep hole, stop digging! And that’s the Savage Truth.

Terry Savage is a registered investment adviser and is on the board of the Chicago Mercantile Exchange and McDonald’s Corp. She can be reached at her Web site,

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