Carl Richards is one of today’s best writers focusing on personal finance. Originally keeping a great blog at behaviorgap.com, The Behavior Gap has moved to the New York Times, and early next year, Carl will release his first book. Look for The Behavior Gap: Simple Ways to Stop Doing Dumb Things with Money on January 3, 2012.
Carl’s articles on Behavior Gap and now his New York Times column tend to focus on the psychological aspects of money and are usually centered around cocktail-napkin sketches like the example below illustrating how as investors we expect trends to continue into the future.
Carl Richards is also a financial planner, and in a recent New York Times feature, he uses an example from his own life to explain how people continue to behave irrationally about money even when they know better. It’s a good indication of why a healthy approach to your finances requires much more than knowing, “spend less than you earn.” We’d like to think that building wealth is as simple as that, but if that were true, anyone who could do simple arithmetic would be financially secure over time.
While close friends and family were likely aware of Carl’s housing situation a few years ago, he’s just now sharing his experiences with the public. How could a smart financial planner lose his house in Las Vegas? How could someone strangers rely on for financial advice find himself underwater on his mortgages? It’s not such a stretch when you understand human behavior.
- We feel comfortable in crowds. When everyone else in our closest circle is behaving a certain way, we feel safe if we are taking the same approach and making the same decisions.
- We expect trends to continue (see the sketch above) even though reality often differs. In Carl’s case, he expected — and everyone around him expected — real estate prices to continue climbing.
- We trust the professionals. Carl qualified for a mortgage at more than 100 percent of his house’s purchase price, according to his mortgage broker. He wanted to believe the salesperson, despite knowing his fee was based on the loan value. Even against his better judgment, he over-borrowed.
Carl’s story also illustrates how easy it is to falsely judge someone’s financial choices from the outside. Now with clients in dire financial situations, as a financial planner Carl is less likely to judge their choices to spend money. Their continued vacations despite the lack of money in the bank could be what is saving their family — or their lives.
You can get caught up in the excitement when everyone around you seems to be making choices which look crazy on paper but seem to be resulting in short-term success. Carl’s example is the real estate frenzy in Las Vegas in 2003:
It felt a little crazy to be shopping for houses that cost half a million dollars, but my income was growing rapidly. Everywhere I looked, people were being rewarded for buying as much house as they could possibly afford, and then some. There was this excitement in the air, almost like static. I started to think that if I didn’t buy a house right then, I would never be able to afford one… We’d go to open houses for $400,000 homes and see lines of couples in their late 20s — younger than we were — waiting to get inside.
He refinanced his mortgage, choosing a low payment option that added to his loan balance each month rather than subtracted. Then the real estate market crashed in Las Vegas, and he became underwater on his mortgage. He could continue to pay but owing more on the mortgage than the house was worth, keeping the house was hurting his finances. Carl wrestled with what he perceived to be a moral obligation to continue paying his mortgage and the moral obligation to take care of his family.
After discussing the issue with other, Carl decided that what he had was not a moral obligation with the bank but a contractual obligation, and he should look at the mortgage as a business arrangement. Any business would reevaluate their financial situation, and if it was a better decision to stop paying the mortgage in order to qualify for a short sale, despite the credit score hit, that’s what he should do.
While this was the logical, mathematical choice, it only became a possibility when Carl felt better about breaking his mortgage agreement. Human behavior plays a larger role than mathematics, even in this case. Again, from the article:
The process of making financial decisions is about more than building a spreadsheet to calculate the answer, because life rarely fits cleanly into a spreadsheet. Our decisions often appear irrational until we understand the whole story.
Would you walk away from your house and your mortgage if you owed more than the house was worth, your loan balance was increasing each month, and you’d be better off financially if you just stopped? I’ve discussed this at Consumerism Commentary in the past, and the results, based on participation from readers, was mixed. Some would, some would not.
Published or updated November 9, 2011.
{ 11 comments… read them below or add one }
I don’t think I would walk away from my house & mortgage because it would pose an ethical dilemma for me.
What Wylerassociate said….Just as with declaring bankruptcy, the situation would have to be extraordinary.
Maybe it’s just me but it seems like overextending one’s self to purchase a home in the manner he did would completely disqualify a person from enjoying a career as a prominently known and respected financial planner. Or at least, it should.
Maybe he’s a writer rather than an advisor these days, but it sure seems like an article like this would make a large dent in his business. I expect that people of all walks of life were caught up in the madness of the bubble though. In my home country of Ireland, friends and acquaintances who you’d expect to be a whole lot more conservative (and, with hindsight, smarter) bought rental properties in Poland, Bulgaria, you name it during the Euro property boom. We’re all geniuses now!
I wouldn’t walk away because I would buy a house for a place to live. You can still live there, and the mortgage payment is what you were told it would be. And I agree with Dan—-I don’t think I’d listen to this guy for advice.
Since I have never defaulted on a loan, I guess that makes me supremely qualified to give out financial advice.
Every home or property I bought over the years, I approached conservatively. If faced with an under water mortgage, I would probably look for some moderation. If that were not possible, I would definitely consider walking away. In the interest of full disclosure, I have never walked away from a contract before.
I agree that this situation is a contractual one. But, I’m so conservative, I’m not sure what I would do in the same situation.
His remarks are so true. When we were running with a certain circle it was okay to borrow money just to take a vacation. We were doing things we never would have if we did not get the idea it was okay (although we should have thought for ourselves). When we were with a very frugal group and paid full price or bought something over the top then that was taboo. Now we think for ourselves.
On the topic of the house. I think I entered into a contract and I should abide by that contract. Is it the right thing to do. Even if it takes forever to pay off the right thing is to pay if off. But easy said and harder to do.
I know someone who had a bank foreclose on them just because the home was underwater. The banks see this as a business/finance decision so i don’t think this should be a moral/ethical dilemma for a buyer.
I don’t think I would walk away, but that’s easy to say having never been in his situation. My husband and I have always been really conservative in our spending. I think a lot of people get caught up in that old “keeping up with the Jonses” mentality. Just because a mortgage broker tells you that a mortgage is affordable, doesn’t mean it will be. A person has to know what is affordable in their own situaton.