Don't Count on the Consumer

The U.S. economy remains mired in a deep recession. How deep, well fourth quarter’ GDP declined 6.3% which was the biggest drop in output in 26 years. GDP figures for the first quarter are not available yet but are expected to be down an equivalent amount. Earnings and profits will also be down substantially in the first quarter after falling 20% in the fourth. These are horrendous results.
There have been encouraging signs in recent weeks and the panic has subsided but the recession is not over. The economy is still contracting and though the rate of decline seems to have moderated there are still problems to overcome. Hope is growing that things will improve even though the banking system is not yet operating normally. In Federal Reserve Chairman Ben Bernanke's words, there are signs of "green shoots," through snow in early spring. The economy is no longer in free fall but it is still in intensive care and the markets may be getting ahead of themselves.
The outlook for jobs however remains bleak. The unemployment rate is officially 8.5% in the U.S. and 11.2% in California. However, the real national unemployment rate is over 10% when you add in those that have been looking for a full time job for more than a year and those under employed (working part time but seeking full time). One out of every ten adults is unemployed and it will only get worse before it turns around.
Unemployment will continue to move higher as businesses downsize in response to falling sales and constrained credit. We have at least eight more months of rising unemployment before it starts to turn around. The unemployment rate is a lagging indicator because businesses will not begin hiring until the economy is expanding and well into recovery.
The lag is usually significant as the charts of previous recessions show below. These graphs were compiled by JP Morgan Asset Management which allows their charts to be reproduced. The gray bars are recessions and the black lines show the market low. The green line is the total return of the S&P500 which increases from the market lows. It is interesting to look at the orange line representing the unemployment rate because it typically builds higher even after a recession is over and the markets have moved significantly off their lows. In many cases, unemployment remains high for months after a recession is over.

The recovery from this recession will be held back by weak consumer demand. The American consumer will not be rejuvenating the economy by borrowing and spending. In fact the consumer isn’t consuming. He has started saving again and paying off debt. Americans have recognized that they need to have a contingency plan in case they lose their jobs or ever want to retire. The current argument that the average taxpayer will spend their tax refunds is faulty. Most taxpayers will save their refunds in case their salaries or jobs are cut. After watching their portfolios self destruct and the equity in their homes disappear, the average American is not spending recklessly. For the first time in twenty years the personal savings rate is on the rise. Debt payments as a percentage of disposable income have begun to fall. The American consumer is scared of losing what they have worked so hard to achieve and is finally planning for that rainy day.

Manage Your Credit Card Debt Away

Every once in a while you find a great website that is truly helpful and not gimmicky. I ran across one such website the other day. It was created by the cooperative efforts of Utah State University Extension and WebAIM.org. The website primarily helps consumers gain control of their consumer debt. It has a great calculator that lets you enter your specific debt information for each obligation. The site then calculates how long, at that rate, it will take you to pay it off and how much it will cost you in interest. You can also see the impact of making additional monthly payments to each credit card or loan.

It will also help you establish an Emergency Fund plan so you are prepared if you lose your job or the unexpected happens. It also has a calculator that helps you determine how much debt you must pay off to qualify for a mortgage.

There is also a section that helps individuals develop a spending plan. It helps you allocate your take home pay and makes suggestions for different expense categories (i.e. food usually comprises 18% to 25% of your income).

The Educational Center has dozens of helpful how to articles on topics as diverse as selecting a credit card to how to protect your self from insurance fraud. These are pithy articles just chocked full of good tips.

You will need to setup a profile with username and password to start exploring this site but it is totally worth it.

Please pass this site on to anyone who has is having trouble managing their debts. It is also a great site for educating teenagers or kids about money. I always wonder how many kids would run up credit card debt if they knew how much it costs. There is a great article offering helpful suggestions for parents on managing allowances.

Powerpay

Manage Debt Wisely - Follow Basic Mortgage Rules

Yesterday’s blog about exotic mortgages and the high estimated rate of defaults is a great lead in to today’s column. This is my second installment of my Rules of the Road. Last week, I wrote about credit card debt and car loans (See my December 12th blog listing). This week’s rule:

Rule #2:
Never borrow more money than you can afford to pay back on your current income.

Many people justify taking on unsustainable debt based on the premise that they will earn more in the future or the asset will appreciate. They are borrowing from their future to sustain their current lifestyle. This is a dangerous strategy. What if you don’t earn more in the future? What if you get sick and can’t work or lose your job? Always live within your means, in case tomorrow doesn’t pan out like you expected.

This includes borrowing to buy a house. Do not buy more of a home than you can afford. You may be able to initially side step this problem by using some of the new exotic mortgages discussed in yesterdays blog but it is a risky strategy.

Your monthly debt payments should not exceed 36% of your gross income. So if you are loaded down with credit card debt or a car loan this will reduce the amount of monthly income you have available for your mortgage, property taxes and insurance obligations.

Here is an example: If you wanted to borrow $500,000 to purchase a house with less than 20% down. You decide not to use an exotic mortgage product but to go with a standard 30 fixed rate loan and buy the mortgage insurance (instead of getting the newer riskier piggy back loans usually in the form of a variable line of credit).

The monthly payment for a $500,000 at 6% is $2,998. To do the standard qualifying calculation, you have to add on your monthly costs for Real Estate taxes (approximately 1.1% in California that’s $460), Property Insurance ($100), Homeowner’s Fee ($30) and of course the Mortgage Insurance ($150). In this scenario these total $739. Added to the monthly mortgage payment, your obligation totals $3,737. If you are using the 36% rule then your annual gross income should be at least $125,000 a year.

To circumvent these rules borrowers are reducing payments only initially by signing up for interest-only loans so their payments are lower. These loans may offer a very low initial teaser interest rate of only 3% so monthly payments are $1,250 versus $2,998 for a few months. The buyer initially qualifies based on the reduced monthly payment. After the initial period, the interest rate resets and the payments escalate. The borrower finds themselves trapped with a mortgage that is devouring more than 60% of their gross income. It doesn’t take much for the borrower to fall behind in his mortgage payments and lose the house.

So here is the moral. Don’t overextend yourself by taking on too much debt. You risk losing the house you’ve bought and your credit rating. It is better to wait then over extend.

Libby Mihalka