A new study by researchers at Vanderbilt University Law School and University of Oxford reveals a strong correlation between approvals for payday loans and bankrupcty filings. Considering that people who are rejected for payday loans have other (limited) options for credit, it’s surprising that the rate of bankruptcy isn’t as high with this group. It’s quite possible that this can be interpreted as a cause-and-effect relationship. That is, being approved for payday loans increases the probability of filing bankrupcty.

Individuals who have been approved for payday loans have a probability of filing for bankruptcy within two years 2.48 percentage points higher than the probability for individuals who were rejected for payday loans.

It sounds obvious, but scientific findings that payday loans contribute to bankruptcy confirm any hunches. Payday loans a short-term loans with fees which, if viewed in terms of interest rates, are very high. Rates of 100% APR or higher are common. The loans are designed to be paid back in two weeks, however, so you only see a 100% interest rate if you roll over from one loan to the next for an entire year.

Most people who have the need to get cash quickly in the form of a payday loan don’t continue the cycle continuously for a year, but many do become repeat customers. The typical payday loan borrower will apply for about five more payday loans totalling over $1,500 within one year after the initial acceptance.

The study shows that interest from payday loans accounts for about 11% of the a bankrupty filer’s total interest burden, and this 11% could be what finally pushes an individual into declaring bankruptcy—the proverbial straw.

These results are consistent with the interpretation that payday loan applicants are financially stressed; first-time loan approval precedes significant additional high interest rate borrowing; and the consequent interest burden tips households into bankruptcy.

The authors of the research discount the idea that individuals preparing to declare bankruptcy quickly accumulate as much debt as possible to maximize bankruptcy’s “benefit.”

While it’s certainly possible to borrow money through a payday loan, pay the entire balance plus interest when it is due, and never become a payday loan customer again, this is not a typical scenario. Furthermore, those who have low credit scores may be rejected by payday loan companies and turn to pawn loans instead, with similarly high interest rates. Yet, the payday loan customers have the increased incidence of brankrupcty.

Do Payday Loans Cause Bankruptcy? [Paige Marta Skiba, Vanderbilt University Law School and Jeremy Tobacman, University of Oxford]
via Research Recap via pfblogs.org

This article was written for Consumerism Commentary by Adfecto, a mid-20s guy with a masters degree in engineering. He aspires to be wealthy and writes frequently for his own blog, Adfecto Abundantia.

When I purchased a home it was not a lifetime commitment. I view a person’s choice of housing first as a financial decision and second as a lifestyle decision. A house gives you place to live and the added bonus of potential price appreciation and tax deductions. If it is cheaper to rent then by all means that is the way to go. Owning your own home can also give you a tangible increase in your standard of living, but personally that is considered a distant second when compared to the financial benefits. What I find interesting is that so many people tend to make emotional decisions about the home rather than rational ones.

Frequently, when home owners find themselves with a little extra cash at the end of every month, the idea of paying off the mortgage is often brought up. Is early payment the right way to use the money? Should the money be invested instead? Is my real motivation to build wealth or to play it safe?

The first step in analyzing this decision is to compare the interest rate on the mortgage to expected investment returns. Historically the S&P 500 with dividends reinvested has returned 10.43% annualized from January 1926 to December 2007, and the current rate for a fixed 30 year mortgage is about 5.76% according to www.bankrate.com. Based on this simple comparison it is plain to see that in the long run you will build more wealth by investing than by prepaying your mortgage.

If you want to further hone this comparison of rates, next you can consider not just the entire history of the stock market, but also every 30 year rolling period of stock market data. Since 1953 the S&P 500 has returned at least 9.34% over every 30 year period which is again well above the interest rate for a 30 year mortgage. Plowing your money into prepaying your mortgage has a huge opportunity cost that will hurt your ability to build wealth.

Why then would people consider prepaying their mortgage? Most people consider their home as a safe investment, and paying off a mortgage as a guaranteed return. A certain piece of mind comes from owing the bank less money. There is a big problem with this argument; there is still a great deal of risk involved with your primary residence!

Some of this risk comes from the fact that the value of real estate is not fixed. It absolutely goes both up and down as many people in Florida, California, and all over the country are now experiencing first hand. Every dollar that is put into a residence is not necessarily money you will get back when you sell.

Additional risk comes from the fact that until your loan is paid in full, the bank still holds the mortgage on the property. The bank will not give you credit for the extra payments made to pay down the debt if you start to struggle further down the line. Even if you are way ahead on your mortgage, a hardship may cause you to miss payments. The bank can foreclose even if you spent years paying down the mortgage balance early.

Investing your free cash into your mortgage is very similar to investing in a bond. It may seem odd, but you are literally investing in a fixed income asset, the mortgage, lent to yourself. The return you get will be equal to the interest you would otherwise pay on your mortgage. One problem that arises is that the bank has first crack at the collateral; your house. Even worse, your mortgage isn’t even a very good deal when compared to the types of bonds; for example, Toyota AAA rated bonds currently pay as much as 7.652%. I bet your mortgage rate isn’t that high.

Furthermore, understanding the nature of your mortgage as a bond brings to light another risk; improper asset allocation. Mortgage prepayment shifts your asset allocation to rest more heavily in fixed income type investments than you might otherwise consider. A 40 year old person should have at least 60% but more likely 80% percent of his/her portfolio in stocks, but add in all of that mortgage prepayment in the bond category and you may find yourself far out of line from you ideal asset allocation.

Another risk related to mortgage prepayment is a lack of diversification. You may think that your mortgage is not very risky because you believe in your own ability to pay. This personal bias can cloud a person from see the true risk factors such as job loss, poor real estate conditions, natural disaster, and a plethora of others. A single unfortunate event can wipe out a large chunk of the equity. A single job loss may bring about a short sale or foreclosure that could wipe out the value of your home. Would you advise someone in your circumstances to invest in individual mortgages? I sure wouldn’t, and neither should you.

Deciding whether or not to prepay a mortgage is another financial and lifestyle choice which depends on several factors, but most of all it is a choice between building wealth (logical) and piece of mind (emotional). People who focus on paying off their mortgage seem to be more in love with their house and the idea of having it paid off than the goal of building wealth. These people are also blind to the risks that come from investing too much of their finances in a single residential structure. I think that for the majority of people the ‘right’ decision would be to keep the mortgage and invest the extra money.

Image credit: Oracio
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Countrywide, the country’s largest mortgage lender, is stepping in to “rework” 82,000 loans totaling about $16 billion. I believe that the lenders and the borrowers are both partly to blame for the mess. Lenders offer risky loans, and customers, happy to hear they can afford more than they anticipated, sign up without realizing they can’t really afford it.

When a company like Countrywide gives into consumer pressure, you can be sure other lenders will follow. While this is good for the economy in the short-term and good for the borrowers overall, it may send a bad message. It perpetuates the idea that there are no real consequences to being in debt. Bailouts extend the ability for people to survive while simply signing their paycheck over to other people and companies like mortgage lenders, electric and cable companies, and credit card issuers.

This is a dangerous thought: As long as you are following the spending trends of millions of other people, you are safe. There will always be changes in regulations or laws to keep the economy somewhat afloat, and if you’re representative of the greater economy, chances are you’ll be kept afloat as well.

While history shows that in general that has been the case it is a highly dangerous way of thinking, because it doesn’t play out that way for everyone, and you have no idea of knowing if it will for you. It’s a much better idea to live below your means and never have to worry.

Ah, student loans. The things that remember you long after you’ve completely forgotten the entire college experience.

Although I finished college in 1997 and graduate school in 2000, loan payments to Sallie Mae have been a constant fixture ever since, like a little wound I’d nurse which just wouldn’t stop bleeding.

Even when making double or triple monthly payments, the amount I owed hardly seemed to diminish at all. I set up direct deposit, did everything I could to nudge that low interest rate down even further, and eventually consolidated my loans, but I was still frustrated, unable to see that light at the end of the tunnel.

Perhaps this was because (and I’m actually facing this number in its entirety for the first time ever right now): that tunnel was pretty darned long. $52,050.74 long. Looking at it actually makes me feel faint.

And that’s just the principal – that number doesn’t even take the interest payments into account. I’m afraid to figure that total out.

I won’t say for a second that my higher education wasn’t worth it – it was just a bit of a hard road to travel, despite my high level of motivation and desire to be self-sufficient. My parents either couldn’t (Mom) or didn’t (Dad) contribute to my college education, so I waited tables like crazy throughout highschool, washed dishes for a whopping $4.50 an hour within the work study program once at college, and got student loans, both subsidized and unsubsidized, to cover the rest.

I still wasn’t anywhere near paying off the 4 years of undergrad study when, after several years in the workforce making double loan payments each month, I decided to go to graduate school. Another $18,000 added to the sum, and that’s because I chose to complete my Masters degree overseas, where it was cheaper.

That loan amount kept swelling like an engorged tick, but because it was in a flurry of separate disbursements, I never really faced the total, just a few thousand here and ten more thousand there. My interest rates were pretty good, so I’d just been paying it down monthly ever since, hoping one day to reach the elusive endpoint.

Last year, I started becoming more financially aware and contributing to my savings account. I was so happy that I had finally amassed some money in savings that was earning 5.25%, but then I noticed that my consolidated student loans were still costing me more than that in interest at a rate of 5.38%. And because of my salary, I don’t get to deduct a single penny of that interest from my taxes.

Because I was just paying under $200 a month, it didn’t seem that bad, but once I really got into crunching the numbers, I realized that I’d been paying around $75 a month in student loan interest, which turned into a big ouch when I looked at the cost annually. And despite all my extra piecemeal payments, nearly ten years later I still owed around $22,000 to my old friend Sallie Mae.

I sought the help of a financial advisor. She explained that although some of my residential and rental property mortgage rates appeared at first to be higher, after tax deductions, my student loans were hands-down the most expensive of all my loans.

Based on her advice, I decided to grab some cash out of my coveted savings account and start hacking away at the remaining loan amount, paying as much as I could whenever I found I had uncommitted funds at my disposal.

My tax refund and all my savings except my emergency fund went right to Sallie Mae, knocking off $10,000 from the total. I moved my emergency fund to a high-yield savings account earning 6% at FNBO Direct, and started funneling every extra penny into that account, elated each time I was able to transfer money in. The interest was a nice bonus, giving me more incentive to store funds at FNBO Direct before surrendering them, never to be seen again. Once there were sufficient funds in the account, I’d do yet another payment to Sallie Mae, $500 or $1000 at a time.

It felt like the wound was hemorrhaging, and I dreamt of having a nice big savings or investment account instead, but I remained committed to reducing that total.

And around 2 months ago, I finally got that total just under $4,000. The end was in sight! I started bringing more lunches, buying less clothing, socking away funds just a little bit more – anything to finish that final lap.

And today, I did it. I sent my final payment of $3,880, and bid my old friend Sallie Mae goodbye with a cheer.

The number was $52,050.74. It was outright terrifying, a giant monster that wouldn’t fit beneath the bed. And as of tomorrow, that number will be zero.

In ten years, I have paid off $52,050.74 in principal, and still more in interest. I say it again because now I like that number; now I’m very, very proud.

With the savings rates falling like bricks lately, there is no advantage to me keeping my student loan payments low while keeping my bank account in the stratosphere. My student loan interest rate is 4.25% and I may not qualify for any tax advantages which would otherwise effectively reduce that interest rate. My savings aren’t earning much more in interest, and after income tax, it’s likely less.

I’ve decided to speed up my student loan payments. I’ll end up with less cash on hand in the next few years, at the same time I might be purchasing a house, but the lack of debt will put me in a better position to afford a mortgage.

This week, I sent $5,000 to my student loan.

The most basic piece of knowledge one needs in order to be in control of their finances is the importance of awareness. Many people will go through their lives blissfully ignorant of their own financial details. Why? For one, ignorance is bliss. The more financial trouble you are in, the easier it is to ignore financial details because it keeps stress out of your life. David Bach is professing tips for dealing with home equity and debt, and for his fourth informative piece, he underscores the importance of being aware of how much your debt is costing you.

First, shop around for the best rates (check out Bankrate.com or LowerMyBills.com to compare lenders’ rates). Then, see if your primary mortgage lender can offer you a deal. But make sure you understand how it works.

For instance, is the loan tied to the prime rate? Is it fixed or variable? Variable rates can hurt if rates keep going up. Determine when that variable rate adjusts and what your new payment amount will be when it does.

Read the fine print: Is there an origination fee (even if you don’t use the loan)? Is there a property appraisal or application fee? Will you incur closing costs? Will your payment amount increase if you’re ever late? And finally, are there fees if you pay the loan back early?

When I was in debt and ignorant of that fact, if I didn’t start writing down my credit card and loan balances, the interest rates, and my monthly obligations—and later entered my information into financial software to track my spending and expenses—I never would have gotten myself in a better position. When you’re comparing home equity products with the intent of making decisions about home equity loans and HELOCs, you will not be able to make competent decisions until you understand the details.

You can’t just stop at the interest rate, either; as David Bach mentions, prepayment fees are important as well. If you want to pay your loan off faster than the provided amortization schedule, prepayment fees can take the place of the interest you think you’re saving. It gets worse. The more customers become aware of the “hidden” fees, the companies seemingly find new ways to confuse and distract.

Seven Ways to Be Home Equity Savvy [David Bach]

Just a week ago Capital One did the right thing by changing its policy about reporting true credit limits to the agencies that calculate credit scores. Hot on the heels of this positive change is another change that could be a good change for the company. Cap One is eliminating its GreenPoint mortgage company, which specializes in no-documentation and Alt-A loans—mortgages generally sold to people who probably shouldn’t qualify for borrowing.

Capital One Financial Corp. said Monday it will cut 1,900 jobs and shutter its wholesale mortgage banking business, a move that comes as lenders continue to struggle in the nation’s housing and mortgage markets.

Capital One said it will shut down GreenPoint Mortgage and eliminate most of the jobs by the end of year. The McLean, Va.-based company will close 31 GreenPoint locations in 19 states and “cease residential mortgage origination” effective immediately but said it will honor commitments to customers with locked rates who have loans already in the pipeline.

“Over the past few months, we have experienced an unprecedented disruption in the secondary mortgage markets,” Capital One Chairman and Chief Executive Officer Richard D. Fairbank wrote in an internal memo to employees. “I made the decision to wind down the business with a heavy heart.”

This isn’t about improving the company’s image by eliminating disrespected business, it’s a liquidity issue. These sub-prime loans are turning out to be not necessarily a bigger risk than expected, but the money is not coming back to the company. Regardless of whether it looks good to the media, Capital One is getting out of the business because it’s no longer the money-maker it was at the beginning.

Thanks to Kai who forwarded me the Associated Press article.

If you’re going to borrow against your home equity, you might want to understand the different options are available. David Bach in a recent column outlined the differences between home equity loans and lines of credit.

Home Equity Loans. Generally called a second mortgage, this type of loan allows you to borrow a set amount that you receive in a lump sum up front. You pay it back over a specified period (typically 10 or 15 years) in monthly repayments. The interest rate is usually higher than a first mortgage but lower than most credit cards, and fixed for the life of the loan.

HELOC. This stands for “home equity line of credit,” and generally works like a credit card. Your lender assigns you a maximum amount up to which you can borrow. You can use only what you need if and when you need it, up to the limit. Interest is typically variable, but usually lower than credit cards because the credit is secured by your home.

There are slight but important differences between the two types of products, and different lenders will throw in additional twists and turns.

Seven Ways to Be Home Equity Savvy [David Bach]