Handling Finances

In many countries, and even in America at one time, people saved to purchase their home. A home would often stay in the family for many generations, and as funds became available, the family would simply add to the house as needed.

In contrast, we’ve been raised culturally to expect a mortgage. Mortgages are called “good debt” and treated as the default way to purchase a house. The banks that profit from this naturally encourage mortgage lending — earning interest for 30 years is a pretty sweet deal, as long as people honor the loans.  Now that it’s become apparent we’re borrowing more than we can handle, many are calling for our government to make borrowing money even cheaper to help people keep their homes.

What would happen if mortgages didn’t exist?

First of all, houses would cost about half what they do now. That’s not to say that if mortgages suddenly disappeared, house prices would drop by half but at 5-6% interest over 30 years, we end up paying twice for the house — once up front to the seller and once over the life of the loan to the bank. This is a somewhat simplistic view of house prices and in fact, house prices would drop even further when you factor in the detail that without mortgages, people would be willing to pay much less for houses than they do now.

Of coure mortgages aren’t going anywhere, they’re just becoming more difficult to qualify for, but it’s interesting to me how universal mortgages have become. Many people are absolutely certain that the stock market will continue to rise at around 10% per year long-term so they see a 5% mortgage as a really good deal. Others can’t imagine saving for a decade or two while renting until they could afford their house.

What I find so fascinating, is that we’ve twisted the American dream of homeownership from the reward for hard work it once was to an item we all deserve. We call it “home ownership” even when we never own more than 20% to 40% of the house, and are totally content to throw hundreds of thousands of dollars to banks for the “privilege” of living in a home we never intend to own.

I’m a big fan of mortgages to be sure, but the same feeling of entitlement that makes us think we deserve a bank’s money to buy a house has lead to a great deal of inflation in housing markets. The “real estate bubble” may have burst with real estate prices dropping nation-wide, but many Americans still treat homes as an investment — hoping that when they want to sell, mortgages will be even easier to get in even higher amounts so that they can end up with a positive return. I wonder how many people compare their “earnings” with the interest they paid over the years.

I wonder how many people simply get the largest mortgage the bank will allow because the banks told them that was the American Dream and because nobody bothered to tell them that the American Dream comes with limits and consequences.

No, this isn’t yet another ‘bash P2P lending’ writeup, I’m actually quite impressed with both the idea and the execution of Prosper.com and LendingClub.com. There are issues surrounding default rates that are really important, but in my opinion, it would be hard to do due diligence regarding the P2P lending and not have a reasonable understanding of default rates and how they’re affected.

The problem with P2P lending in my opinion is that the interest rates don’t quite work the same way as with money market accounts and as the lending sites don’t point it out, it’s very easy to miss. Quite simply, you only earn interest on the money that’s actually loaned out — as the loan is slowly repaid, you earn less and less unless you reinvest the money you receive in another loan.

For example, if you lend out $50 at Prosper and earn 8% interest on the loan, you’ll end up with $56.40 at the end of the three-year period.  Due to the magic of compound interest, you’d earn the same amount in a money-market account at 4.0%.  Why the big difference?  You’re not earning interest on any interest paid and you’re not earning interest on any principal paid.  In short, in a money market account, each interest payment immediately starts earning interest itself.  At Prosper, you have to reinvest — or make another loan to earn interest on the money that’s paid back to you.

It’s a simple concept, but something that often gets overlooked when people get into P2P lending.  Of course, if you reinvest the payments you get back every time you accumulate $50, your ‘losses’ are much lower.  In fact, if you have around $1600 invested, you’ll accumulate about $50 in payments each month, so on average, you’ll only lose about 0.1% due to money sitting around waiting for your next loan.

It’s not a problem that makes P2P lending worthless for lenders, but you should carefully consider the cost if you plan to invest less than a thousand dollars in P2P loans.  Not only will your returns be significantly slashed as a large percentage of your money sits doing nothing, you’ll have so few loans that even one default could easily wipe out your potential profits altogether.