Preying On America's Poor
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2014-02-16 10:30 by Karl Denninger
in Consumer , 273 references Ignore this thread
Preying On America's Poor

It just never stops, does it?

Last October, Jeffrey Shavers, a hotel maintenance worker in Chicago, took out an extremely unusual $300 loan. Shavers might have liked to use the money to visit his daughter, a college student in New Orleans, or to buy his 10-year-old son a new bike. But he couldn’t, because Shavers never actually saw the money. The cash went into a locked savings account that he couldn’t access. “It’s like an abstract $300,” he explained.

But the money wasn’t just sitting there. It was helping him build credit. Shavers began paying back the loan, which was orchestrated by the Local Initiatives Support Corporation, a community-development organization, in $25 monthly installments. And for each $25 that he paid on time, another $25 entered the locked savings account.

One question: What's the interest rate on this secured, and thus risk-free $300 "loan"?  Oh, and please include any fees involved.


Because if it's more than 1/4% Jeffrey is being robbed blind and he doesn't even know it.

I read this article carefully and nowhere did I see a description of the interest rate and fees.  If you remember my basic premise in such things it is that nobody ever hides good news, so I surmise that the effective APR on this "loan" is somewhere beyond the orbit of Pluto, all things considered.

And one must consider all things.  See, interest rates are not abstract.  A large, indeed the largest contributor to them is risk.  Risk of monetary devaluation and non-payment, for starters.  Then there is the basic time value of money.

But a secured loan that is in fact secured with cash has zero risk.  It's even safer than Treasuries, since there is always the chance the government will default.  Yes, it's vanishingly small but not zero.

In this case the risk in the event of a default is zero since the actual cash is kept where the "borrower" can't get to it.

So what is the interest rate?  The article implies it may be zero, because it references "by the end of a year" and another $300 in payments, which of course is 12 x $25.  The article also claims that doing so will "earn" a 689 FICO score.

I don't know about that latter claim and I'd love to see strict proof.  

I bet there isn't any, and here's why.

Credit scores have a number of determining factors.  Payment history is of course part of it, but so is the time in the file, types of credit, how many new inquiries and accounts are opened and debt-to-credit ratio.

One year of history, all on-time with no base might be able to get you to "Preferred" status, which is what a 689 is.  But you won't stay there the minute you get a card and run up more than that $600 in credit as you'll start to bang on the debt-to-credit ratio almost instantly.

The other question is exactly how this account is reported.  Is it reported as a $300 credit line with zero available at incept or is it reported as a $600 credit line, half used?  I bet it's the latter as I fail to believe the former would lead to a near-700 FICO score, but that's false; it is in fact always a zero-available-line credit account all the way up until you get to the $600 and cash it out, because the entire balance is locked up where you can't get to it.  In other words, it's likely these guys are gaming the FICO system, and eventually FICO will get wise to this and put a stop to it.

Second, what's likely to come next is an offer for a secured VISA, where you deposit that $600 and can use it subject to that line, and only that line.  At an exorbitant interest rate, of course, and once again, this is a zero-risk "loan" from the issuer.  

Is this of "benefit" to the low-income person?  Probably not.  The $600 accumulated certainly would be, however, provided it has no interest expense associated with it.  In other words that program, if it terminated with the low-income person having the $600 in a savings account at a credit union would wind up being quite useful in the event of an emergency (e.g. your car breaks down.)

If, at the same time, it leaves you with the ability to obtain a standard (no gimmicks such as deposit-held) credit card it might even be of better use.  But -- and here's the problem -- in order for that to be the case you can't use that card beyond your ability to pay it off at the end of the month, because the minute you do you're going to start banging your credit score in a bad sort of way.

In other words this program would be of use under one, and only one, circumstance:

  • The low-income person pays no fees or interest during the 12 months, and winds up with $600 saved in a credit union savings account.  He or she now has a cash cushion against disasters -- a small one, but still, a cushion.  Many "small" disasters are enough to economically kill low-income people, so this amount of money, while nowhere near enough to have socked away, is a good start and might rescue such a person -- once.

  • The low-income person does not obtain a gimmicked credit account next, but a standard one, and never charges more than they can pay off in cash at the end of the month.  In other words they never carry a balance, ever.  This is how you evade paying interest, of course, which is ruinous to lower-income people (especially at the rates they're likely to pay on a credit card!)  Even so-called "Elite" credit card offers have ruinously high interest rates compared against the zero-risk level -- 10% or more per year and that compounds if you carry a balance.

So if, and only if, those two above parameters apply then I can support such a program.  But that's two big "ifs", and nowhere in the article does it reference this.  Instead what it talks about are all the "benefits" of credit, like being able to buy a car you can't actually afford on credit because you can blow a third of your annual income on the purchase (which is idiotic on a vehicle, incidentally, and especially so on a used vehicle, particularly when one considers the total cost of ownership including fuel, maintenance, mandatory insurance and repairs!)

Now look at the final load of crap in this article:

But credit gives people a greater ability not only to weather shocks and take control over their finances. It also helps get their money off the sidelines and into circulation. “It allows them to spend their own money,” Morduch says. And that, too, is how America gets ahead.

That's a lie.

It allows people to spend money not yet earned.  

That's what credit is, and the problem is that the unearned income (as of that point) with which you will pay is speculative.  If you lose your job or have some other sort of financial disaster, and by definition when you're in the lower economic strata those are more-likely and if they happen are more likely to be severely-debilitating, you're screwed.

Your first priority in life as a new adult ought to be to sock back six months of living expenses.  Yes, that's a lot of money.  Yes, that will take time -- probably several years of time.  But then, and only then, can you afford to use credit, and only to the extent that the payments do not impair that six month cushion because the risk of an income disruption never goes away.

Does this mean you can't have the "better" apartment, the "better" car, etc?  Yes, it does.  That's not bad, it's good.  It means you live within your (modest) means on a voluntary basis which is a very important life skill.  It requires that you say "no" every single day to those that entice you to violate that premise, and this is a life-long habit that will serve you well.

If you adopt it.