Tuesday, November 22, 2016

Why poor get poorer

Today I was thinking about one of the reasons why poor people get poorer.

Of course there may be many different reasons: education, government policy, de-industrialization caused by globalization, etc.

But, for a family, there is indisputably a key factor that makes things better or worse: the access to cheap credit.

Let's make an example: let's suppose that your monthly salary is  2,5 k€. Now, you want to apply for a mortgage. Let's suppose that the mortgage you need is for buying a house which is worth 300 k€.
The bank tells you that if you ask for a mortgage which covers no more than 60% of the value of the houe, ie you have savings for the remaining 40% , then you are given an interest rate of 3%.

Instead, if you ask for a full mortgage, that is the mortgage covers the full price of the house, they ask you 4.5% of interest rate.

For a thirty years old mortgage, let's see what this means.

First case: you have savings. Monthly payment: 912 €

Second case: you don't have savings. Monthly payment: 1520 €

In the second case, the monthly fee is 67% higher.

In the case "no savings", the weight of the monthly payment becomes 60% of your salary, so it is likely that the bank will not even give you the mortgage, unless they are provided with extra-collateral, ie not only the house that you are about to purchase, but also the house of your parents.

And, if the real estate market is in a bubble condition, so prices are high, and you cannot provide extra collateral, chances are you will be obliged to stay under rent. So, your landlord will become richer and you will become poorer because you are paying the landlord.

You can imagine that in such conditions, poorer will become poorer.

So you may end up saying that a policymaker that eases, thanks to low interest rates from the banks, the purchasing of property for poor people is a hero. This is wrong. You see, you should FIRST ask yourselves why real estate prices have risen so much in the last twenty years, with respect to stagnating wages. If you grant, by means of a political decision, easy credit to everybody, everybody will buy a house, and prices will skyrocket so we will only generate a bubble that, sooner or later, will pop leaving families without a house, since the residual value of their dwells will not cover the mortgage they still have to pay. This is exactly what had happened in 2008 in the USA. As soon as the teasing mortgage period ended, ie you had to start paying back the principal AND the interest, not only the interests, families could not pay back the monthly fee and, since there was no more demand for extra houses (because everybody had been speculating on buying a first, second and maybe a third house) they could no long sell the old house at a price that was higher than the original price they had paid for at the beginning. The house of cards collapsed. Everything was generated i) by the silly political decision to grant a house to everybody and ii) the large use of financial instruments that kept hidden the risk of a collapse. Again, these financial tools had been de-regulated by the government and their used spread out without control. Again, with the ok of the government, that turned their eye to the other side.

The real issue, here, is that real estate has grown much more than wages. This has prevented many families from affording to buy a decent house in a decent district in a decent town for years.

In a nut shell, one of the most important reasons behind having middle class people getting poorer is the fact that real estate market has skyrocketed, wages are flat, no possibility for extra savings, so high cost of credit from banks, or longer duration of mortgages.
Don't believe government when they say they grant easy money and easy policy for common people: it is going to have a very temporary effect. Stay out of debt for easy consumption or for expensive houses and keep savings for project that will lead to an increase of income in the future.

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