Joe, an average office worker, has been pre-approved for a $300,000 mortgage plus he has a three credit cards with a total limit of $25,000 and a constant bombardment for other ‘pre-approved’ cards. Joe earns $48,000 per year at his office job as a pencil pusher. After taxes and deduction Joe earns $3000/m. Joe’s favourite phrase is ‘Carpe Diem’ and has no savings.
Joe has always wanted a large house with a white picket fence. So, he buys one for $300,000 (no money down), amortized over 25 years at 4%, his payments are $1578/m. He bought in at a good time though, prices have seen dramatic appreciation so his house is now assessed at $350,000.
Joe lives near a lake, he loves water skiing so he decides to buy a boat (and truck to haul it around, of course). The price tag for the new toys comes to $50,000. He doesn’t have the money but, luckily, his bank offers him a Home Equity Line of Credit (HELOC) on the equity that now exists in his home. The HELOC rate is a low 5%. The great part is that he doesn’t need a re-payment schedule, he can pay interest only but decides to pay it off over 25 years. Payment = $290/m.
Joe pays for everything with credit and tries to pay off the full amount every month. Unfortunately, there always seems to be a good deal on something that he needs.
Month one: 50″ plasma & home theatre combo sale. Price = $6000
Month two: a much deserved vacation away from work. Destination, Cabo. Price $3000
Month twelve: etc. By this point Joe has somehow seen his credit card debt maxes out at $25000. At 18% financing, his monthly interest payments are sitting at $375/m.
Total income: $3000/m
debt service liabilities: $2243/m
Other liabilities (food, property tax, utilities): $500/m
Net income: $257/m Joe is still keeping his head above water (although he’s not really paying down his debt and he still has no emergency savings.
Unfortunately, interest rates have risen. His house now costs $1800/m (at 5.5%) and his HELOC is up to 7%, so the payments are $350/m. Property taxes have also gone up to help pay for the infrastructure in the new subdivisions.
Total income: $3000/m
debt service liabilities: $2525/m
Other liabilities (food, property tax, utilities): $550/m
Net income: -75/m Yikes! To cover the shortfall, Joe gets another credit card.
Joes truck needs a new transmission, $2000
His house needs a new water heater, $275
Economic downturn means that Joe gets ‘downsized,’ he’s a smart guy and gets a job quickly but has to settle for $45,000/yr, or $2800/m
Monthly payments keep increasing, he sees the power of compounding… in reverse!
Joe has fallen victim to the Jaws of the Credit Trap!
5 responses so far ↓
1 Traciatim // Jan 5, 2009 at 20:27
Are you sure a bank would offer Joe a 300K mortgage in the first place? I make less than Joe, but not by a crazy huge amount and I was only offered a mortgage up to 145K, and even then I only took one for 105K. Maybe banks should tighten their standards of lending . . . Oh wait.
2 wc // Jan 5, 2009 at 20:52
hehe, nice.
Thanks for your comment.
Seriously, although this is a fictitious example to illustrate the point some of the numbers came from experience (mine or others). For example, when shopping for a mortgage for my first house many moons ago went something like this:
Me: I’d like to buy a house. How much do I qualify for?
Mortgage Broker: Who do you work for?
Me: A large and notable high tech company called, “Will be near bankruptcy after the bubble and will struggle to remain solvent for years to come.”
Mortgage Broker: Really? You qualify for 300k!
Me: What?!? wow, that’s more money than I can imagine.
Mortgage Broker: oh yeah, we could probably get you more, but we’ll be conservative because your stock options won’t vest for a while yet.
Me: uhm. ok…
Luckily, I had a fear of zeroes at the time. I bought a small house and took a mortgage for less than 100k.
3 Traciatim // Jan 5, 2009 at 22:05
Wow, I couldn’t imagine trying to sustain a 300K mortgage on an income of 50K, that would be one terrible existence. You’d be worried about every little bump in your finances, and would be miserable.
My family goal was to buy a nice house we can afford and at the time we only had my income. Now my spouse is out of school the hope was the income would just about double and we’d be smooth sailing. That hasn’t materialized yet, but we’ll get there hopefully. I can’t wait until our family income tops 70K and we only have a 105K mortgage, that should be plenty comfortable.
4 Avoiding the Credit Trap | the Wealthy Canadian // Jan 6, 2009 at 12:02
[...] The Credit Trap [...]
5 wc // Jan 6, 2009 at 18:50
I agree, I would rather find an alternative to buying a $300k with $50k income, I wouldn’t be able to sleep at night.
Hoping that my house will appreciate, or that I and/or my wife will get raises doesn’t help pay the bills. Personally, I tend to look for worst-case (or at least bad-case) scenarios. If I were to lose my job then I may have a tough time to pay the bills regardless, but a $100k mortgage would be far easier to manage than $300k.
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