Improving financial literacy
Metro reports this morning that 6% of adults in the UK – a million people – regularly use their credit cards to make their mortgage payments:
More than 1million people use high-interest credit cards to cover their mortgage or rent payments, debt experts say. Six per cent of householders have turned to plastic to pay for the roof over their heads during the past year, according to housing charity Shelter.
Young people struggling to stay on the property ladder are most likely to use the ‘rob Peter to pay Paul tactics’, despite risking long-term ruin. Many credit card companies charge interest between 15 and 18 per cent – up to three times higher than typical mortgage rates.
Clearly – and I would expect all my readers to understand this – borrowing at 15% to pay off debt contracted at 6 to 8% is financial lunacy. (It’s called negative carry and you have to have a damn good reason to hold a position like that for any length of time.) There may be an argument to do so occasionally for one or two months if you are facing an exceptional and short term liquidity shortfall as the ease and convenience (ie opportunity cost) of using an existing committed line of credit (ie a credit card) offsets the extra interest cost. Indeed this may be the case for some of these people. However for most I suspect it reflects two failures that should be addressable: firstly it reflects a basic lack of financial (mathematical?) literacy among a substantial proportion of the population, secondly it reflects a lack of appropriate basic banking (lending) products, or awareness of those that do exist.
A cynic would say that it is easier for a lender to price (and thus provide) ‘credit card’ debt and so this is what is offered. It is true that credit card risks – being very granular, and widely distributed, and having a relatively long history (through various economic cycles) – are more easily modeled using statistical techniques. Indeed this is why you haven’t seen distress in the market for credit-card backed securities as opposed to mortgage-backed securities: they tend to behave as modeled and so the stress tests used to structure these securities tend to reasonably accurately represent real life losses under economic stress. Indeed, the high interest rates reflect the probability of high expected losses. Looked at from a portfolio point of view, credit card receivables are less ‘lumpy’ and losses more normally correlated and distributed than most other kinds of lending. Of course one of the reasons that mortgage loans cost less and are typically seen as ‘safe’ (or at least safer) assets is that they are secured on real property (and in the case of a primary residence, seen as the first in the queue for repayment as people are loathe to lose their homes.) The problem with this (as is being brought home in spades by events in the US) is that the lender faces two residual risks – one the value of the underlying real property can change (go down) and the transaction costs involved in ‘realizing’ (ie foreclosing: taking ownership and liquidating the property to repay a delinquent loan) are typically very high (it depends on the legal regime and labor costs but these can often be as much as 20-30% of the value of the property, especially for lower value homes.)
So what can be done? Schools, but also financial institutions, need to do a better job of educating their citizens/customers. You need a driver’s licence to drive a car. Perhaps you should have a borrower’s licence to take out a loan? Ok perhaps not – I’d much rather see a market solution, and I suspect there must be a long term commercial benefit to financial institutions who take this responsibility seriously (and not just as a box-ticking exercise under regulatory duress.) Perhaps new innovative start-ups like Kublax will start making a difference in this area.
Next, financial institutions need to pro-actively offer better overall financial solutions to their customers. For most high-street banks however there may be a inherent conflict of interest in promoting more intelligent solutions to credit cards. (Don’t misunderstand me, credit cards are a fantastic product when used appropriately – ie for 20-40 day ‘working capital’ rolling credit, but they should always be paid off in full, or at worst used for very short term cashflow smoothing as per above.) Ideas like the various ‘One’ accounts, which automatically offset deposits with mortgage debts should be extended to consolidate all assets and liabilities. An idea I’ve been thinking about for several years is to create a company that would help individuals manage their personal balance sheet in a professional way. I suspect that the vast majority of people don’t really know what a balance sheet is, and amongst those that do, few think of their own finances in this way, other than perhaps momentarily when applying for a mortgage or writing a will. Perhaps I am naive but I believe the concept of a balance sheet – stripped of jargon and intellectual snobbery – is one that the vast majority of people could grasp if presented in a friendly and clear manner.
Finally, if banks won’t help their customers contract more appropriate debt, I hope more people will make recourse to markets like Zopa for unsecured financing. Aside from getting better rates, participating in a market like Zopa forces people to spend a little time thinking about their balance sheet and how credit markets work (even if they probably wouldn’t articulate in this way.) Zopa is user friendly and welcoming in a way that banks – despite I’ll admit some efforts to improve their public perception – just aren’t.
Of course none of this will help anyone who is bound and determined to spend more than they earn (or more accurately will earn), but I suspect that many of those struggling with managing their finances would welcome a helping hand in having a better understanding of their financial situation and the options available to them.
Next up: taking option theory to the masses. 
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