Why We Borrow Until It Hurts

If the subprime mortgage mess has taught us anything, it is that we are leverage addicts. Nearly all of us are — from Northern Virginia, where we bought big houses with no money down, to Wall Street, where traders borrowed cash to make bigger bets on the housing market.

Seeing Zero Percent Interest Until Next Year! on envelopes causes us to tear them open, find the Web address, enter some information and send new credit cards hurtling toward our mailboxes. Financing cars for three years is so passe; we finance them for six or seven. And now we buy — or used to buy — houses with pick-your-payment mortgages. We are leveraged from here to China. U.S. consumers spend more than 14 percent of their after-tax income just to stay current on household debt.

The question worth asking now is: Why do we love leverage so much that it hurts?

The simple answer, according to personal finance experts, is that we want more — more money, more house, more car, just more, more, more. We often think we deserve more. Leverage gets us more. With historically low interest rates, leverage is the easiest and quickest tool to get more stuff.

The problem is that too much leverage has a downside that is easy to overlook. When everyone else is using leverage so successfully to get more, do we wonder what will happen if interest rates go up? Not so much.

This is where the simple answer breaks down. So we turn to the more complicated answer: Blame our brains.

That’s what Jason Zweig thinks. He’s an investing guru and journalist, and as many people wonder how we all could have been so dim-witted these past few years, he provides one possible answer in a book called “Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich.”

Zweig has studied several experiments examining people’s brains when they make personal finance decisions. The results, he said, are surprising.

“You would expect logically that the borrowing and spending of money would be emotionally painful to people because having money is intrinsically a good thing, and having less money would have to be worse,” he said. “Going from more money to less would be painful.”

If only that were true.

“When people borrow and spend money, it’s really the reward centers of the brain that become activated,” Zweig said. “When you borrow money, you are thinking not about the long-term consequences but the short-term result: You have more cash in your pocket. The pain you are going to experience down the road of having to pay — that’s in the future, it’s remote, it’s abstract.”

Now think about the housing boom, particularly about people borrowing way more than they could afford.

“If I borrow a million dollars to buy a house, the fact that I can’t afford to borrow it is dwarfed by the fact that I’m getting a million dollars,” Zweig said. “That’s just really exciting. And the entire subprime industry acted as the credit card industry has acted: focusing people’s attention on what money can do for you right now and taking your mind off having to pay a lot of money down the road.”

It’s all so easy and cheap. This may sound perplexing, but money is inexpensive. Inflation levels have declined sharply since the 1970s and ’80s, pushing interest rates much lower. For example, Americans spent 10.8 percent of their after-tax money on servicing debt back in 1982, when the federal funds rate was 14.5 percent. But as interest rates declined, making money cheaper, our debt — and the amount we pay to stay current — shot up, peaking in 2006, when interest rates were at 5.3 percent.

“Like any other product, if its price falls, households will consume more of it,” said Mark Zandi, chief economist of Moody’s Economy.com. “Rates fall, so households take on more debt.”

In the current downturn, the leverage problems of the consumer have been closely tied to the leverage problems on Wall Street. Homeowners took out mortgages to buy houses they couldn’t afford. Wall Street then borrowed money to essentially buy up those mortgages, betting leverage would spur bigger returns. But when interest rates went up, the over-leveraging of homeowners could no longer be ignored. They couldn’t keep up with their payments. Say hello to the foreclosure lawyers. Say goodbye to the value of those mortgages on Wall Street.

Through it all, whether on Wall Street or Main Street, our brains were focused on gain and oblivious to risk. That needs to change.

Barry Glassman, a financial planner and investment manager in Virginia, recalled a conversation he had a couple of years ago with a client who was disappointed that his stock portfolio had only returned 9 percent while the market gained 15 percent. Glassman has conversations like this all the time. It’s his job. And it’s also his job, if he’s doing it well, to talk to his clients about risk vs. reward, about how much money is worth leveraging for the opportunity to earn a specific return. Clients like this one often want to bet more than Glassman thinks they should.

He was gentle but blunt with his client: “To go for 15,” he told him, “is not going to help your retirement as much as losing 40 percent would hurt your retirement.”

In hindsight, everything that has happened to consumers and on Wall Street in the past eight months might have been avoided — might have — by considering the risk vs. reward advice from the realm of personal finance, from instructive conversations like the one Glassman had with his client. “One needs to look at the worst-case scenario,” Glassman said. “We must ask, ‘What happens if we are wrong?’ ”

Zweig said most of us focus on what we’re getting, when we should be asking, “What am I giving up?”

“What will this cost me? The only way to do that is you have to get the numbers and you have to look at them,” Zweig said. “If you don’t feel comfortable you can understand them yourself, you have to ask someone to walk you through them.”

He suggests consulting online calculators that can quickly total up how much something bought using leverage will actually cost in the long run. Bankrate.com, for instance, has calculators for mortgage payments and debt settlements.

Zweig’s other idea is to ask your spouse or partner: What do we want our retirement to look like? What do we want to do? Where do we want to live? If it’s Hawaii, use photos of the beach for your screen saver. What all this will do is center you in the future while you’re making financial decisions now.

“If you can paint the future with some emotion, you may be able to distract yourself from all this emotional noise in the present,” he said. “The only way we will change from a borrowing and spending society to a savings society is if people can motivate themselves to think concretely about the future. But it doesn’t come naturally. That’s a muscle you have to build up with exercise.”

Of course, it’s worth remembering — despite all the downsides to leverage — that some leverage in the economy is good. It spurs spending, which moves products, which keeps corporate bottom lines chugging along, which creates jobs and gives people spending money to keep the circle of dollars in motion. Very few people could afford to buy a home were it not for the mortgage system — used in the way it was set up, with buyers putting 20 percent down and only qualifying for a loan amount they could actually afford.

Leverage is also ironic, in that to swim our way out of problems caused by too much leverage, consumers need to employ a little leverage. After the Fed lowered interest rates last week, CNBC’s queen of financial reporting, Maria Bartiromo, appeared on “NBC Nightly News” to discuss the implications. She said, “Perhaps that will spur us to spend money, borrow money, and get money moving again in the economy so that we can get this economy back on track.”

You have been warned.

By Michael S. Rosenwald at the Washington Post