Today we continue with the book review on The Two Income Trap. This part will cover chapter six and seven of the book. For part one of this review click here. For part two of this review click here. For part three of this review click here.
Chapter 6: The Cement Life Raft
Lots of people get into financial trouble when things go wrong in their life. Back in the 1970s the USA had laws that regulated how much interest a bank could charge you. The rate was different state to state, but if you lived in New York, you could easily find out what the maximum was. Then inflation hit. The savings and loan crisis started by interest rates not being high enough to be above the inflation that was running rampant at the time. According tot he authors the solution was to deregulate the banking industry. A supreme court ruling allowing banks to set interest rates based on the state they were in, instead of the state the customer was in, allowed banks to move to the state with the highest cap on interest rates. If a Governor wanted to attract nice white-collar jobs to the state which they ran, all they would have to do is drive up the maximum chargeable interest rate. The banks would flock there very quickly.
“Credit card debt has increased accordingly: from less than $10 billion in 1968 (inflation adjusted) to more than $600 billion in 2000, an increase of more than 6,000 percent.” according tot he authors this increase was because banks didn’t have to worry about the interest rate they could charge if you defaulted on a payment they could drive up the interest rate to whatever they chose. The reason for this increase in debt is the two-income trap. Families were in a major bidding war for the best homes int he best school districts and banks were loaning them the money, even if they’d be hard pressed to pay it back. With less discretionary spending, when things went wrong people turned to credit cards.
The cement life raft is the life line banks started throwing people who were in trouble because of job loss or medical bills or other emergencies. Banks would see people in financial trouble as great customers because they would carry a balance and pay the minimum. Miss a payment? banks loved that because now they could convince you to consolidate the credit cards into a line of credit and secure it against the house. For families in financial distress this resulted in freed up room to help try to spend their way out of the trouble they were in. Banks would even make these loans knowing full well that they would end up foreclosing on the property. “Loan-to-own” is what the book called these loans. Banks were doing alright with this type of loaning, so long as housing prices continued to climb, they could sell the house for more than they loaned, and for more than the cost of the foreclosure proceedings.
Banks found that sub-prime loans were extremely profitable. They gave these loans to people who really couldn’t afford them. On top of that the extra fees and higher interest rates had the bank push regular middle class people towards this type of loan even though they could have affording a traditional prime loan. They wrote this book before the great sub-prime market melt down of 2008, so we can all see the consequences of bank greed. They took billions out of neighbourhoods in the form of high fees and high interest.
The solution to this problem of bankers gone wild is to regulate the industry again. the authors suggest a national interest rate cap linked to inflation. This would avoid the issues of the 1970s when the S&L crsis hit. If inflation was ever to hit the double digits then the interest rate cap would go up as well to allow banks to cover their profit margins. The other solution the authors suggest is political activism, getting involved and writing to senators and congress men and women. In Canada our regulated system of banks has kept us from these issues. Some financial bloggers, like Gail Vaz-Oxlade have suggested that banks are trying to push for a more American like system of credit. I think the authors are right about getting involved. We have to push back on the grassroots level, if we don’t, then one day we could see the same thing happen.
Chapter 7: The Financial Fire Drill
For six chapters of this book I have read about what government should do. When I started this book after finding out what the two income trap was, all I wanted to see were personal solutions. What can a person or family do to avoid the trap? This chapter was the answer to that burning question I had.
The authors ask a series of questions that I think every family should ask of themselves.
- Can your family survive without one income?
- Can you downshift the fixed expenses?
- What is your emergency backup plan?
The questions posed focus on two income families. If one of you loses a job can you make the cut backs to keep going? will you fall short? If you are going to fall short, then you need to do something. If you have the means to keep going without one of the incomes, then chances are you can get through the disaster intact.
The second question is interesting. Most financial planners tell you when you get into financial trouble to cut back on variable expenses, things like the dinners out and the extra spending. problem is most families are already being squeezed for this discretionary money. The authors suggest that before financial trouble hits you downshift fixed expenses. Start paying off debt and cut the size of the home mortgage. This will probably mean moving. If you answered “No” to question number one then moving to a cheaper more affordable home is the way to free up money in the budget. When times are good is the time to do this. When financial trouble hits you don’t want to be trying to sell the house because you will be in a worse bargaining position. Sell it now. Move to a cheaper neighbourhood.
Fire departments in North America will often be heard saying that the time to plan for a fire isn’t when walls have gone up in flames. Now is the time to practice. You need to do this as well with your finances. During a family financial meltdown is not the time to try to figure out what to do. Now, during the good times is the time to practice. So to all my readers, today is the day you all lost your jobs. Yes, thats right for the next month, assume you have no income. Layoffs never happen nicely and they never have all the writing on the wall that you would expect. Today I’d like to see how you’d do with a fake layoff. Practicing a financial fire drill will get you in shape for when something does happen.
On March 1st,2010 I’ll report how we did with this challenge. I’d love to see some of my readers take up the challenge as well. Remember for the next month the money coming in from work won’t used to pay the bills. Pretend you’ve been laid off.
Maybe I’m too late, maybe your house is on fire already. The authors give some advice here to “Avoid the blame game” There is no sense in both of you blaming each other. Something lousy happened and you weren’t ready for it. You will survive. blaming each other will drive you apart from each other just at time when you need each other the most. “Hold on to your Treasures” during financial stress banks will try to give you every type of credit offer, they will offer to consolidate your loans. The authors say not to do this. Why trade non-secured credit card debt that gets wiped out in a bankruptcy for secured debt against the house? You are in financial trouble. The bank is looking to make sure they get their piece of your assets. By moving you over to a secured debt against the house, the bank ensures you will keep paying. If you want to keep the house, then debt secured against the house is not discharged in bankruptcy court.
The last section is to “plan strategically.” Pay the bills in order of importance. As Dave Ramsey puts it, pay for the four walls first, shelter, food, clothing, transportation. The rest can wait, credit card bills can wait and even though the calls will start. they can all wait, because you can still go through bankruptcy. If you have to go through bankruptcy court the authors suggest that you wait till most of the financial crisis has passed. If it started because of a job loss, wait till you have another job. The idea of bankruptcy is to give you a fresh start. By waiting you can really get back on your feet. You can’t file again for 6 years, so you might as well do it at the best time to get your leg up in the world.
Conclusion
I liked the book. The explanations of the trouble that is hitting the middle class gave me insight into how to avoid those mistakes. I didn’t like all the solutions for government. I think personal responsibility is more important. I think a person has to be in touch with their finances. I loved the last chapter. The financial fire drill is the best part of the book. If you live in a two-income family you really owe it to yourself to read the book. Understand the pitfalls and come up with a plan to avoid them.
Back on January 4th 2010, I talked about Cheap Affordable Housing. My friend were looking at an area close to the steel mills in Hamilton. A place of traditionally low-cost housing. I think after reading this book, they have it right. Picking a house that will have a low overhead for a mortgage. Keeping their fixed costs in check will help them through any rough financial patches they come across.
