I have to ask something difficult of you this week. I need you to pretend you are a banker. Then I’d like you to decide if you would lend money to a family I will describe.
Here are the basic facts. Sam is married, has children and will soon be taking care of his aging parents and, possibly, his aging in-laws. He believes he is securely employed. He is respected among his peers— although some think he should mind his own business more and their business less.
By most standards he has a nice income, about $100,000 a year. Sam, however, likes to point to his best year. That was four years ago. In 2007 he earned $118,000. He thinks your lending should be based on that amount, or more, because he thinks there is a lot he can do to increase his income.
If you’re thinking Sam tends toward optimism, you’re right. He generally likes to spend next year’s income today. Lots of lenders know him well. So he has a sterling credit history. He also owns a very valuable house. Even when his income is down he can point to the value of his house as collateral.
“I’m good for it,” he assures.
Your problem is that you are one of the new bankers we’ve started to meet since 2008. Unlike the bankers before then, you actually want to get your money back. So you tend to ask a lot of awkward questions.
Fortunately, Sam doesn’t mind. He’s never been turned down for credit before, so why shouldn’t he be able to borrow more now?
Sam is also a savvy guy when it comes to borrowing money. He has a really neat home mortgage. It’s interest-only so his payments are minimal, particularly since the interest rate is about 3 percent. It’s also a flexible mortgage, so he can pretty much borrow more whenever he likes. He doesn’t know what the limit is. He never discussed it with his lender because, well, it wasn’t an issue.
And that’s where you come in. Sam’s home mortgage is almost a one-of-a-kind. It literally has no limit. Basically, the limit is whatever you set. And he’s a good customer.
The current balance is $448,000. Owing 4.5 times his annual income may seem like a lot, but you have to remember it’s an interest-only loan so his payments are lower than they would be on a typical mortgage.
But that mortgage balance keeps going up. Sam spends more than he earns very consistently. This year he’s spending $174,000— quite a bit more than the $100,000 he’s earning. Worse, even if he was hitting home runs, he’d be spending $24,000 more than he’s earning.
He also has another, rather weird, debt. Sam wanted to build a fund to help pay the expenses of his aging parents. So he put money into a kitty for it every year. What his wife and children don’t know, however, is that he “borrowed” from the kitty each year. Today, it’s full of his handwritten IOUs. He adds another IOU each year to pay interest on the money he has borrowed. Today those IOUs total $211,000.
Where did the money go?
Sam spent some of it on his wife and children. But he doled the bulk of it out to his parents and in-laws because they asked for it and he couldn’t say no.
“It seemed like the right thing to do. This isn’t a problem, it is money we owe to ourselves,” he says.
Unfortunately, that won’t pay the bills. Those IOUs aren’t the same as cash or CDs. When he actually needs the money he has promised, he’ll have to borrow it, adding it to the borrowing he already does.
And that’s about to happen. His aging parents need a lot more medical care. They will also be moving in with him, so he’ll be paying for their food, shelter, transportation and other expenses.
So, dear reader-banker, you know the odds are he’ll be spending a lot more than he earns for years. That makes you wonder if your bank will ever get its money back.
So tell me. Would you lend Sam more money? What limit would you set?
Your answer may be helpful to 535 lawmakers in Congress because Uncle Sam is the borrower. His income, spending and borrowing numbers have a lot more zeros in them, but they are in the same exact proportions as the figures for our friend Sam.
Send me an email at email@example.com, put “Uncle Sam” in the subject line.