By Mitchell D. Weiss
Houses and college degrees have two things in common: Both cost of lot of money and both depend on specialty financing products to help make them more affordable. But which came first? High prices or budget-friendly payment plans? Consider the latest offering in consumer financial engineering, courtesy of private equity firms and crowdfunding companies.
The lenders' pitch is Faustianly straightforward as in, "You need cash to fund all or part of your (housing) down payments and college degrees. We have plenty of that and we're willing to let you use some of it in exchange for a piece of the action." It's a takeoff on the corporate venture capital model that goes something like this: most assets lose value -- or depreciate -- over time, as with refrigerators and lawnmowers; houses, however, usually do the opposite. These increase -- or, appreciate -- in value. And sometimes they do so quite rapidly, particularly after a market disruption causes prices to be reset at significantly lower levels.
In terms of their future earnings potential, people also appreciate in value when they enhance their human capital by acquiring more skills, experience and education. But both these "asset categories" require investment capital to realize their economic potentials. Enter the opportunists.
The Magic of Affordable Payments: In the case of a house, the financial proposition is equity-based -- a percentage of the upside as measured by the difference between the buy- and sell-prices. In the case of the person, it's royalty based, where the payback is a share of his or her future earnings. But why is it that houses and education cost so much? Are these prices purely market-driven (supply versus demand) or is something else going on?
Housing prices are influenced by many factors including locational attributes (proximity to work, transportation, schools, recreational facilities and so forth), as well as a tax code that rewards indebtedness with mortgage interest-deductibility. However, prices are also boosted through financial alchemy -- creative ways of transforming unaffordability into affordability. Adjustable-rate mortgages are a good example. Homebuyers are lured by the below-market monthly payments (for now) and the hope of bigger, better, more beautiful houses before the higher payments kick in later on.
The exorbitant price of higher education is also made possible with financing. In this case, favorable payment structures are further enhanced by government and financial services industry policies and practices under which loans are approved, not necessarily because they can be repaid, but rather because they cannot be avoided. It's an attitude that's led to an unprecedented expansion on the part of the schools, which in turn has increased the sector's costs and, therefore, the need for even more consumer borrowing as a result.
Until these market-morphing methods are either corrected with legislation or influenced by more economically-conscious consumer choices (particularly in the case of higher education), homebuyers and students should tread carefully when it comes to financing structures that insidiously encourage over-borrowing.
Read the Fine Print, Do the Math: When it comes to adjustable loans, I suggest projecting the worst-case scenario and see whether your budget can accommodate that. For equity- and royalty-sharing arrangements, devise a series of house- and income-appreciation scenarios, and calculate the APRs for each.
For example, I read about one company that makes education loans in exchange for a percentage of the borrower's pretax earnings for a 10-year term. The lender also states that it would limit its total payback to five times the original loan value, should the borrower hit the livelihood lottery. The way the math works, if that maximum were to occur during the course of the repayment period (10 years), the loan's APR would be 49 percent. However, if the borrower were to strike it rich within five of his or her post-college years -- which may not be entirely unrealistic, because royalty-based lenders have so far been highly selective in their approval processes -- the APR would double to 97 percent.
So you might want to think twice before choosing an adjustable-rate mortgage at a time when interest rates are poised to increase, an equity-sharing deal when housing prices are on the upswing, or an income-sharing arrangement at the dawn of a promising career.
This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its affiliates.
Mitchell D. Weiss is an experienced financial services industry executive and entrepreneur, adjunct professor of finance at the University of Hartford, a member of the board of the university's Barney School of Business and co-founder of its Center for Personal Financial Responsibility.
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