This post is respectfully dedicated to the memory of Chief Petty Officer Shannon Kent, the first American female service member to die in combat in Syria.
Quick, what are the three biggest financial items on your mind right now? Chances are that if you’re like most people, your list probably looks like this:
- Paying down debt (whether a mortgage, car loans, student loans or credit card debt)
- Retirement savings (or lack thereof)
- Protecting from the risk of bad things happening
Take a step back and consider this for a moment – there is an entire field of professionally qualified advisors dedicated to each of the last two areas, i.e. saving and investing as well as insurance, but there is barely any customer-oriented objective advice available on the first. And yet, take a look at the average person’s income and expenses: it’s more than likely that debt servicing is eating into anything between a third and maybe even half of their income!
The effect of credit decisions made in single moments( as in the purchase of a house, a car, or getting a student loan) or over the course of many small seemingly inconsequential decisions (such as with credit card debt), is the single biggest driver for the utter lack of financial security that most Americans today face. But there is no place or person they can reliably turn to tell them objectively how much credit is good for them, what the impacts of specific credit decisions are likely to be on big life matters, such as careers they want to pursue or life paths important to them, such as starting a family or getting married.
The effects of poor credit decisions become devastatingly obvious at the worst possible times: when the graduate realizes that the major she took a $140,000 loan for will pay her a measly $34,000 a year for the foreseeable future, or when the homeowner realizes that interest rates CAN actually go up.
Four big reasons why credit advice is needed
Your immediate inclination may be to dismiss these instances to suggest that all of these can be addressed “if only” people were a little smarter about the decisions they make: buy the less-fancy car, don’t make so many impulse purchases on your credit card, etc.
But that is not all there is to the story: there are four big and fairly intractable reasons why it will always be hard if not nearly impossible for the lay person to take solid credit decisions that are in their best interests:
Or, in plain English, conflicts of interest. Let’s say you are out to buy a house and shopping actively for mortgages. No matter how much research you do or how knowledgeable you are, you have no visibility into which of the 25 or more mortgage options the broker has available pays him or her the most. But guess what – he or she absolutely does.
Regardless of how ethical they are, the fact that they put bread on the table because of these loans you take out will have a significant influence on the mortgage they eventually recommend to you based on your “unique circumstances”. Since the incentives are set by the manufacturers of these loans, it only makes sense that the most profitable of these are the ones that have the highest compensation tied to them. And no prizes for guessing what the source of those profits are…
In fact, this is exactly what happened in the investment industry about twenty years ago. The realization that financial “advisors” were being compensated based on which stocks or funds they sold to investors led to the rise of fiduciary rules and the rise of transparent fee-only planning, and that trend is not going to reverse anytime soon.
I think the exact phenomenon has been occurring on the credit side as well, and the rise of buy-side providers of impartial advice will go a long way in providing holistic and consumer-oriented guidance.
Closely related to the one above is another barrier that’s almost impossible to overcome, at least in a capitalist economy: the existence of information asymmetries. Companies that design credit products, i.e. loans, and credit cards and the like, have access to immensely powerful knowledge and insight into two areas that consumers never will: the aggregate of how consumers behave, and second and more importantly, the nuances of how costs will arise and laws will impact the lending contract depending on future and uncertain situations.
Manufacturers do this for a living, and they are intimately familiar with the exact dollar consequences of even the seemingly smallest nuances in the wording of the product. Here is an example:
Out of curiosity, I spent a significant amount of time trying to understand the nuances of student loan repayment terms for federal loan programs: something a large percentage of Americans have to grapple with constantly. It took me, as a trained CPA and credit industry professional, several hours to decode the complexities of something as small as how and when interest gets “capitalized” versus “accrued” on various repayment plans.
Yet that small difference can make a very big impact on what a borrower ends up paying back on a fair-sized student loan over ten or twenty years. So is she going to spend her time mastering the intricacies of whatever profession she studied for, say medicine or law, or is she going to acquire a second masters’ degree in federal loan repayment programs?
Even if she did, there’s no way she’s going to be able to intelligently assess probabilities tied to each scenario, so as to make a smart decision, but you can bet her lender will know exactly, based on prior student loan portfolio behavior.
There is large-scale prevalence of “innumeracy” in the United States, with significant portions of the population being unable to make basic assessments involving numbers. And when you add to this the fundamental human cognitive limitations in assessing exponential relationships like compound interest, the problem gets much worse.
Having access to a professional advisor who is trained in making these assessments is one of the best ways to avoid paying hundreds of times the cost of hiring one, in poor credit decisions
Cognitive and behavioral biases
Last but not least is my favorite bugbear: cognitive and behavioral bias. There is plenty of evidence in the literature that humans are fundamentally incapable of overcoming certain types of bias even after you make them aware of these, and train them to overcome them. For example, humans simply cannot objectively assess things like their own impending deaths, or evaluate the likelihood that a poor credit decision on their part will decimate the family’s financial security.
For this to happen effectively, psychological distance and other behavioral guardrails are absolutely critical, which is a big part of the value that professional advisors bring to the table
Challenges to providing objective credit advice
While the need for objective credit advice is compelling, there are equally daunting barriers to making its availability a reality. Primarily:
- People are not aware of the hidden cost of poor credit decisions. And when they do realize a mistake, the prevailing wisdom on “personal accountability” drives them more towards shame than an objective assessment of the systemic drivers that led to these decisions in the first place. Unless I feel immediate and pressing pain, it’s not very likely that I am going to seek out something that is even very obviously to my benefit – this is just human nature.
- Who will pay? – This is a classic example of the “who will bell the cat” scenario. Closely tied to the reason above, if I have to pay real dollars now for some unknown benefit in the future, no matter how real, chances are I’ll go the friendly “free” mortgage broker next door who’s only too willing to lend his or her “expertise”, rather than shell out a few painful hundred dollars today for a decision that will likely save me hundreds of times that amount in the future. And this is assuming that all advisors will be of uniformly high caliber, which is a stretch in any event.
- Standards and mechanics: A far less daunting, yet significant challenge is that it will take time and very meaningful effort to develop a set of objective standards relating to credit. In the investments field this problem was not as huge because there was already a large group of academics at the best institutions who were already studying portfolio theory because there were plenty of people interested in finding out how best to make money in investments. But in the field of credit, other than a few economics and law professors who study things like poverty and bankruptcy, the state of the art has not progressed as far as it might have, had it been powered by the right industry tailwinds.
So is all hope lost? I hardly think so.
While the utopian future of a professionally qualified independent credit advisor at every street corner may be a distant vision, there is much that can be done today to lay the foundation and increase the likelihood of smarter and more prudent credit decisions without all that investment and cost to the industry.
Here are a few starter ideas:
Certified credit advisor designation: While having advisors who ONLY specialize in credit is not viable, it is more than possible to create an industry-wide competency in providing objective financial advice. This would pair extremely well with existing designations such as those for financial planners, attorneys and tax accountants
Objective credit product markers: Just like physical products come with safety and risk labels, such as “Contains wheat or soy”, etc., credit products can also be marked when the most risky features are present, such as highly variable payments, or the possibility of big payment shocks. These are explained ad nauseam in the disclosures today, but having bright and graphic labels can possibly be a big first step towards more prudent credit product selection.
Holistic credit scorecards: We are all pretty familiar with credit scores as they relate to credit, but these are only indicators to the credit industry. While our credit scores certainly indicate the likelihood that we’ll honor our credit obligations to credit providers, their relationship with how much we should take on given the other factors in our lives is certainly extremely weak. Just because someone qualifies to take a $1 million mortgage doesn’t mean it’s smart for them to do so. Having a holistic scorecard that covers two to three big areas of smart credit management, such as debt capacity, extent of contingent liability, as well as payment variability, could go a long way towards helping to alert people to taking on more credit than they can prudently support.
Any one of these measures will be a big step towards helping people drain away less of their hard earned money in needless costs of credit and more towards positive wealth creation and value-adding activities.