Wednesday, June 3, 2015

The Two-Income Trap

Common belief is that those who declare bankruptcy lack the self-discipline and morals to live within their means and pay their debts. After extensive studies of people who declared bankruptcy in the U.S., Elizabeth Warren and Amelia Warren Tyagi paint a very different picture of the reasons why people go bankrupt in their 2003 book The Two-Income Trap: Why Middle-Class Mothers and Fathers are Going Broke.

If we go back to the 1970s, the typical family with children had a father who earned an income and a mother who stayed home. Thirty years later, the typical family with children had both parents working. It’s natural to assume that this means the modern family is better off financially, but the authors show that this isn’t true.

According to the authors, U.S. families entered into a bidding war for housing in good neighbourhoods near good schools to give their children a safe place to grow up. Between the explosion in housing prices and other higher inflation-adjusted costs, “after an average two-income family makes its house payments, car payments, insurance payments, and child car payments, they have less money left over, even though they have a second, full-time earner in the workplace.”

The effective marketing of debt by financial institutions has certainly played a role in egging families on to larger purchases. “Just a generation ago, the average family simply couldn’t get into the kind of financial hole that has become so familiar today” because “the average family couldn’t borrow very much money.” Easy access to high-interest debt has changed all that.

So, adding a second income does not give more disposable income than people in the 1970s had. But living on two incomes adds significant risk. Now there are two people who might lose their jobs, and the family can’t maintain the life they want for their kids on just one income. While in the 1970s a mother could step into the workplace if her husband fell too ill to work, two-income families have no such safety net now.

The authors certainly aren’t calling for a return to the single-income family. They want some measures that will help the typical two-income family. They would like to see public schools give parents more choice of where to send their kids. This would make it possible to send kids to a good school but live in a less expensive neighbourhood.

Another measure they’d like to see is a cap on interest rates tied to the prime rate (e.g., prime + 10%). “If a family does not have the income to qualify for a loan at a reasonable rate, then they should not get that loan.” I certainly like the idea of financial institutions being forced to be more selective when lending.

The book also contains some very detailed advice on how to proceed if you are already in financial trouble and must go bankrupt. Apparently, collection companies use some unpleasant tactics to try to collect on loans, even after the loans have been discharged by the courts.

Although this book is getting a little dated and is U.S.-centric, it still provides an interesting counter to the usual story that those who go bankrupt are self-centered and lack morals.

8 comments:

  1. What y see arround me is that the second income purpose is for lifestyle inflation purpose*. We have an average familial income and we are able to stash away half of this every single year. Still run a damn good lifestyle at least compared to the 1970s ! The difficult part is just to do this without anyone noticing whats going on ;-)

    *Stay away from the dealerships and 50% of the work is done. Restaurants, trips and clothes are the next cash-sewers. Most middle-class could save 10-20k$ per year on these items, fund RRSP TFSA and RESP and become financialy independent in no time.

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    1. @Le Barbu: It sounds like you've got a good system for yourself. I can imagine, though, that a Canadian couple each making median income might have to stretch hard to buy a home in a neighbourhood where they'd like to raise their kids.

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    2. @Michael, I agree that could be a stretch if they want to keep up with the Joneses and make no plans for themselves to get ahead. Everyday I see peoples with 2 kids, owning a 3br-2ba house lurking for bigger place, buying new cars every 4 years and heading south at least once a year. They complain about being tight all the time and saving nothing...

      I think the prime to pay for a good place to live offset the longer/complicated commuting for work and school. My rational is that most people I know living away from services are bad at $$ math. If one live at the optimal location for his needs (not wants) he will be more efficient with his time and money. I would be willing to pay about 50k$ more for every 10km closer from the epicentre of my activities (even tough, right now I am 3km from this sweet spot!). I got to listen to people in the ditch explain their rational for the oposite all the time.

      I think borrowing is to easy and gas is to cheap. The hangover will be tough...

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    3. @Le Barbu: It's true that there are people who make poor financial choices. But there are also people who live very frugally except for attempts to bring up their kids in a good neighbourhood.

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    4. These people are making the good choice, especialy if "bring up your kids in a good neighbourhood" means a safe neighbourhood, with decent public schools and public services (playground, library, pool, arena etc). Frugality may be the price to pay but quality of life worth it. Sometime the best solution would be to rent the place you live even if it's counter-intuitive in the low-interest/easy-borrowing era we live in.

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  2. Don't social issues come in to play here as well. Gone are the days of the nice neat family. Isn't the divorce rate getting into some very high percentages now. Plus I heard a recent study that we transitioned to more singles then official couples about a year ago?

    I think these factors play way more into this than lifestyle inflation etc.

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    1. @Paul: Yes, you're right. This was discussed in the book. A two-income family stretched to the limit with fixed expenses like a mortgage have big problems if they divorce and have to take on the cost of another rent and maybe another car. Back in the 1970s, a non-working mother could go to work after a divorce to make up the difference.

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  3. RE: Housing Prices. Check out this interesting article on The Star's website on the inflation adjust house prices from 100 years ago to the most recent selling price of the exact same house. Most were sold for 10x the inflation adjusted costs.
    http://www.thestar.com/news/gta/2015/06/04/if-only-you-had-bought-these-toronto-houses-in-1915.html

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