There have always been more people who wish to own homes or automobiles than people who can readily afford them. For the larger part of history, those people would simply make do with what they could afford: a smaller house or a rental, a clunker of a car. But in recent years, as we are now well aware, lenders stepped in with “solutions” to help under-qualified borrowers — whether they had poor credit, insufficient down payment, irregular income, or all of the above — take out loans despite their shortcomings. Today, we call those solutions “creative financing.”
While some creative financing solutions have been helpful, many others have been misunderstood and ultimately caused long-term problems for borrowers, lenders and local economies alike. Here are some recent examples of creative financing gone wrong.
Home Equity Loans
Before the housing bust, we were brainwashed into believing that real estate was the only constantly appreciating (rising in value) asset we could ever own. Hindsight is 20/20, of course, and we now know this is simply not true. (We have even come to remember that, in fact, real estate prices are cyclical, just like stock prices.)
That aside, there is another problem with the argument above: even if a home does appreciate, the only way to capture any of that appreciation in the form of spendable dollars is by selling the property. So lenders invented home equity loans and home equity lines of credit, which allowed homeowners to borrow some or all of their equity.
Home equity loans have been around for decades in the form of “second mortgages,” but never had the mass appeal as they did in the past decade. Their ascent into the mainstream is explained in detail in a New York Times article, which explains how advertisers helped shape homeowners’ perception of home equity loans.
“Marketing executives knew that “second mortgage” had an unappealing ring. So they seized the idea of “home equity,” with its connotations of ownership and fairness. The campaign worked. The amount of home equity loans outstanding grew from $1 billion in 1982 to $100 billion in 1988 — in part because a portion of the loans were tax deductible, as the ads often pointed out.”
During the real estate boom of this decade, home equity loans enabled homeowners to use their homes as ATM machines: they drew from their home equity to consolidate other debts, finance home renovations or pay for boats, cars, college or vacations. Today, borrowing from your home equity is next to impossible. Not only do many homeowners simply not have any equity — but even those who have are faced with tight-fisted lenders and subjected to financing requirements many cannot meet.
Bi-Weekly Mortgage Payments
Paying half of your mortgage payment every two weeks instead of the whole payment once per month adds one extra, thirteenth payment at the end of the year. Do it for years on end, and ultimately you will shorten the life of your mortgage and, as a result, the total interest you end up forking over to your lender. Sensing the opportunity, many middle-man companies stepped forward to “assist” customers in paying their mortgages on a bi-weekly basis — and charged “an enrollment fee of a few hundred dollars, and often a monthly handling fee,” for the privilege, as this MSN Money article points out.
The problem? You could very well work out a bi-weekly payment plan with your lender on your own — without having to pay a dime in extra fees. In addition to that, so many homeowners end up selling their home or refinancing before paying off their 30-year mortgage, that those accelerated payment schedules end up reducing their cash flow for little, if any actual benefit.
With the exception of very few situations (picture someone who is 100% sure they would never again move to a new home, for example), bi-weekly mortgage payments are a creative financing tool that ended up lining third-party companies’ pockets at the expense of homeowners.
In her book Debt-Proof Living, personal finance expert Mary Hunt explains how vehicle leasing came about:
“In the 1980’s, as new car prices crept higher and higher, new car sales began to slip. People were trading their cars for new ones every seven to eight years, not every three to four years as they had been in the good old days of the auto industry. Another problem: people couldn’t afford the payments on the more expensive new cars.”
How do you get people to buy new cars more often? Leasing.
Using slogans such as “you only pay for the part of the car you use instead of the whole car”, dealers rather easily persuaded people to sign two- or three-year leases with low up-front deposits and monthly payments. While numerous problems arose (such as confusion over actual prices, interest rates and mileage limits), auto leasing became wildly popular and is now promoted by virtually all auto manufacturers.
Leasing may make sense for a narrow segment of the driving population. If you have strong reason to believe that you will only need a car for a two to three years and you don’t want the burden of having to sell it once you no longer need it, and you don’t drive more than 15,000 miles per year, you may be better off leasing than buying. But for most people, purchasing a vehicle — particularly a used one — makes most financial sense.
If you do decide to lease rather than buy your next car, however, be careful: increasingly, manufacturers are extending lease terms, offering leases as long as five years. Locking yourself into a five-year lease pretty much negates the biggest draw of leasing: its short-term committment.
Stuck in a lease that no longer makes sense for you? You could try to transfer it to someone else. Read our article on getting out of a car lease for the details.
Cash Back or 0% APR Deals
In the beginning of this decade, auto manufacturers faced a string of problems affecting their sales: a recession caused many consumers to rethink the need to purchase new cars, the Sept 11 terrorist attacks scared even more consumers into spending withdrawal and the jobless recovery that followed helped matters no further. So the automobile industry invented a neat marketing trick that they continue to use even today: 0% APR or cash-back offers.
How do these work? A manufacturer would offer buyers the option to choose a 0% loan (if financed through the auto dealership) or a certain amount of cash back. The cash back would typically be applied as down payment for the car. Figuring out which makes better financial sense aside (a number of online calculators, including this one at SmartMoney, can help you with the math), these offers have a number of drawbacks.
To begin with, they are typically reserved for “premium credit” buyers. In other words, you’d need a high credit score to qualify — and many people who hope to take advantage of those offers don’t. Many buyers also don’t realize that these incentives are offered by the manufacturer — not the car dealer. So even if you qualify for a 0% loan or $750 cash back, you should continue to negotiate with the dealer: there will still be room to push that sticker price lower. Finally, those offers tend to be available only on the car models that the auto makers are trying to push the hardest. As gas prices hit record highs in the summer of 2008, for example, you could see generous 0% APR or $5,000 cash back offers for many SUVs. Whether a gas-guzzler was a good fit for your automobile needs or weekly gas budget was another question.