Clitheroe on the borrowing trap

“Financial literacy” is the new buzzphrase when it comes to the sharemarket. But it's the vexed issues of lending finance and property development that have brought a new wave of misery to property investors. Again and again sophisticated promoters catch people off-guard – especially in the wake of the successive property collapses, at Westpoint, Fincorp and ACR.

Today Eureka Report catches up with the nation's best-known spokesman on financial literacy – Paul Clitheroe, the chairman of the Financial Literacy Foundation.

Clitheroe has been monitoring the debate surrounding housing affordability and the level of personal credit debt being carried by Australians. A crucial issue to emerge from the debt debate has been the level of financial literacy education, or the lack of it, that has accompanied a deregulated financial services sector and whether this lack of education is adding to the debt problem.

The interview

Monique Wakelin: A residential property is probably biggest purchase most Australians will make – either as an investment or a home. Do you believe that educating people to be more financially literate will act as a “self-regulator” in regard to borrowing?

Paul Clitheroe: There is an inherent conflict in consumers asking a lender, 'How much can we afford to borrow?’ While a lender wants to be repaid, the individual answering this question is sometimes rewarded by commission on the loan. So, the more the consumer borrows, the greater the profitability of the transaction.

So, yes, I do see financial literacy as a self-regulator in regard to consumers taking on debt. What many people fail to recognise is their ability to repay the debt or how external factors might impact the amount owing, such as an interest rate rise. Financial literacy can help people understand concepts such as debt, interest rates and risk, which can be applied to situations such as buying a house.

Has the culture changed when it comes to the relationships we have with financial advisers and service providers and do borrowers understand?

Yes. Dinosaurs like me will remember that as young adults, the bank manager was a loan regulator. To get a loan required a savings history, a deposit. In 1983 my wife was outraged when her income as a teacher was disregarded in our loan application as “she may get pregnant”. So in the past the bank manager was certain to ensure we borrowed conservatively. Today, however, lenders are fully aware they have a product called credit and they are sellers of that credit.

It is quite apparent that borrowers are often full of enthusiasm to borrow and to do so quickly. This often leads to little consideration of what happens if interest rates rise. Also illness or redundancy can lead to significant financial stress.

Can you comment on the practice of debt consolidation and whether it increases the borrower’s risk?

On the face of it debt consolidation is a terrific idea. Take your credit card debt, personal loans and other high-interest debt and consolidate this into your home loan at about 8%, or a personal loan at about 10%, and you will be paying less interest. But what consumers forget in the excitement of lowering monthly repayments is that they are often converting short-term debt on consumption into long-term debt.

Consolidation works well if the consumer lowers the rate of interest and makes a strong commitment to repaying principal and interest as rapidly as possible. It works very badly if the consumer consolidates personal debt on consumption or depreciating items such as a car into a 25-year home loan and fails to recognise that the fundamental problem is that they are spending more than they earn. All too often I find the consumer does not cancel the credit cards paid out by the consolidation and in a couple of years they have rebuilt their consumer debts and have a higher home loan from the previous consolidation.

Borrowers seem to be well aware of this, and I am seeing consumers with little equity being refused consolidation. Unfortunately, if consolidation happens, there seems to be little awareness by borrowers (or advice from lenders) that unless consumers address the basic overspending problem, the issue is going to get worse, not better.

Many young and first-time property investors may be tempted to think that financial literacy doesn’t apply to them because they are “investors.” What are some of the traps you have seen them fall into?

Over-borrowing due to over-confidence is a real problem. “It’ll be right” is a good, positive Australian attitude, but when it comes to taking on debt, I strongly suggest a visit to the Understanding Money website to do a budget and find out more information about borrowing.

Sadly, I am getting an increasing number of young people telling me that over–borrowing is no great problem because bankruptcy is “an easy option”.

Is there a price to be paid for more choices and freedom when it comes to creating financial security?

Increased complexity is the inevitable result of offering consumers more choice. The variety and number of financial products and services is staggering. The intricate nature of many products makes it challenging even for seasoned finance professionals to understand, let alone ordinary Australians.

This situation alone highlights the need for better financial literacy amongst Australians. Financial literacy isn’t simply about having the appropriate knowledge of financial products. It is also about recognising areas beyond your expertise, and taking appropriate steps to solve a problem.

Where do you think the balance needs to be drawn between a free market and financial regulation?

This is a challenging issue. Regulation is vital, but personal responsibility and knowledge are essential for consumers to protect themselves. Take investment scams for example. Thousands of consumers have been drawn into “get-rich” schemes, pyramid schemes, property scams and “high-return, low-risk” investments that have had a serious impact on many retirees.

Regulation can never be expected to fully protect consumers. It is difficult to see a regulation model that would provide such certainty. With many scams, such as Nigerian schemes being taken up over the internet, regulation is an ineffective tool.

There needs to be a balance between appropriate and effective regulation and financial education. Financial literacy is a key ingredient in a modern economy. Financial literacy gives consumers the knowledge to make informed decisions and ensures people are better equipped to make the most of the choices available to them. The knowledge required is not intense. It revolves around basic money management, and an understanding of risk and return.

Can you give us an overview of the types of initiatives the Financial Literacy Foundation is taking, particularly in regard to young people and particularly in regard to educating investors?

The Financial Literacy Foundation is committed to helping all Australians better manage their money. One of the ongoing challenges faced by the foundation is creating ways that effectively target different groups. Fortunately, there is significant interest being shown by Australians in being better with money and the foundation is tapping into that interest. For example, from 2008 all Australian children will benefit from a concerted effort by all of our schools – government, Catholic and independent – to integrate financial literacy into the curriculum. This will happen from kindergarten right through to year 10.

Children are at a stage of their lives where everything is a learning experience. They’re impressionable and don’t yet have established patterns or routines.

It’s important children establish good money management habits at an early age. Financial literacy is a skill for life and provides a foundation for creating a better future.

Similarly, investing is about putting your savings to work. The foundation has created a number of resources for investors, including the Understanding Money website. The site contains a section on investment, covering key topics including risk and return, managed funds and other important information.

Also many companies, including major employers such as Australia Post (specific examples of these can be found in our workplace brochure) have introduced financial literacy into workplace training. The foundation is working actively to assist companies to include financial literacy into the workplace. What's more a number of universities are recognising the importance of financial literacy as a key factor in the future success of graduates and are planning to introduce financial literacy courses.

Why do you think teaching financial literacy is such an urgent need today?

Financial literacy is one of the most enduring and important skills a person can possess. Money is something that affects all Australians. Much like life, death and taxes, money is one of life’s enduring constants.

Despite Australia’s growing wealth, money is not universally understood.

This is especially true when borrowing money. Australians are exposing themselves to greater debt levels than ever before. There are many people in varying stages of financial awareness – and they are not restricted to any particular socio-economic group.

Understanding money can help people make better financial decisions, regardless of their income or financial situation. I believe better financial literacy is critical to alleviating some of the financial problems people find themselves faced with.

Do you think it has become more important than it was, say, 20 to 30 years ago.

The nature of money has changed enormously in recent years. Where money was once just a physical commodity it now predominantly exists in electronic format; 20–30 years ago you either had money to pay for things or you didn’t – it was as simple as that. People understood that in order to purchase goods or pay bills, you had to save.

These days, with the availability of instant credit, people are losing touch with their understanding of money. Efforts to make financial transactions easier and more streamlined – such as credit cards, online banking, and direct debits – have in fact divorced us from appreciating it. For many Australians, money exists as an abstract concept.

It is also very easy to spend money, via credit, that in effect we have not yet earned. This can lead to serious problems if it causes individuals to continually spend more than they earn.

Property Q&A

This week I answer questions on:

• My daughter wants to buy a house and land package. Help!
• We want to buy two investment properties.
• Now it’s landlord’s insurance on top of everything else.
• DIY due diligence makes for a costly search

House-and-land alarm bells

I read with great interest your article about new house and land packages, Why it’s cheaper on the fringe. It provided very useful information for me to pass on to my daughter and her husband who are looking at borrowing (in my opinion) too much money to buy such a property, compared with the lack of equity they will have in it. Their response is that they intend staying in this new home “forever”, so the lack of equity doesn’t matter a lot in the initial stages and the bank insists they have mortgage insurance. Needless to say, their excitement at the idea of having a new home is clouding judgement on the financial realities. Do you think there should be some sort of system whereby land developers have to give a breakdown of costs that make up the price of land they are on-selling to the public?

Such a breakdown of costs would vary from developer to developer and from state to state. However, there is nothing to prevent a prospective buyer from asking that question of whoever is selling the product. What prospective buyers of new, outer-urban house and land packages need to become conversant with is the difference between their purchase price and the market resale value of such a property once it is constructed. Perhaps you should suggest that they do some homework in this regard and determine what a comparable, existing property similar to what they are looking at and in the same area has recently resold for. At least that way they have an idea of the level of equity, or lack of it, they will be starting with.

Such a revelation may create greater incentive for them to pay a higher amount in mortgage repayments in order to increase that equity a little quicker. Mortgage insurance is for the benefit of the bank, not the mortgagee, so insist they look very carefully at the details of such insurance. Some lenders insist on mortgage insurance if the loan amount is high, so you pay the premium and the lender gets the benefits in the event of a default. There is a degree of danger in the “staying in this new home forever” mindset.

Census data and Supreme Court records on applications for foreclosures on properties shows that “unforseen circumstances” are one the biggest causes. What may be manageable when a young couple are both working can turn into a financial nightmare in the event of a job loss and extended period of unemployment, an unexpected illness or other unforseen life events that severely disrupt the household budget. I suggest that they need to work out what their exit strategy outcomes would be if they were to face such an event before finally committing themselves to the purchase.

Two investment properties

We are considering buying two investment properties, probably apartments. We are looking at buying them in the same block or the same neighbourhood so we can have one agent manage both instead of having to deal with two different agents. Is this a good strategy?

It is vital to choose properties in prime locations with timeless architectural style, but you should resist the urge to stick to just one location or property type. The major metropolitan areas of CBDs have a variety of property styles and not all of them grow in value at the same time or at the same rate in any property cycle.

Spread your risk by diversifying your property holdings with a range of styles, prices and locations. This ensures your investments benefit from seasonal and cyclical variations in capital growth and rental supply and demand. It also minimises the risk of any unforseen issues, such as new infrastructure or a rash of new apartments suddenly springing up in one area and adversely affecting values.

Even if you do find one agent who can manage both properties, you will be charged for both. Don’t allow the management issue to cloud your judgement in regard to the selection of good capital growth and diversified assets.

Landlord’s insurance

I have just received a notification from my property manager suggesting I take out landlord’s insurance for an investment property I have recently bought. I already have building, contents and public liability cover. Is this just another unnecessary product that I’m probably already covered for?

No it isn’t just another unnecessary product! One of the biggest mistakes I see is investors assuming that a standard home and contents policy will cover them for any eventuality. The reality is that there are circumstances that are unique to investors as opposed to home buyers. The type of coverage landlord’s insurance gives relates to events such as rental default or any accidental or malicious damage caused by tenants. The cost of this protection is very little compared with the potential losses it covers.

A costly search

We are helping our eldest daughter buy a modest apartment and have been concentrating on inner-urban areas. Much of the time factor in searching for properties has been taken up in getting contracts checked out or making sure the property is basically sound. At least we can eliminate properties that don’t measure up, but we have also missed out on ones that do make the grade. This process adds considerably to the cost of the whole deal and is often not taken into account when we look at affordability. The building inspections and solicitor’s checks can add up to quite a bit of money. Is there a way we can check these areas ourselves?

Unless you are very familiar with property or conveyancing law, then a do-it-yourself approach can end up costing a great deal more than what you may save in fees. For the trained eye, checking a standard residential contract is relatively straightforward and usually a solicitor will check a contract at no charge if they are assured of doing the conveyancing work once the purchase is made.

It is not a simple process and the laws are different in each state and territory. The same applies to ensuring you engage professionals when it comes to building inspections. A better approach is to carefully narrow down the number and type of properties you are interested in, paying particular attention to their condition and concentrate on doing the due diligence on those, rather than using the scattergun approach in the hope of buying something. In the current rising sectors of the market, fierce buyer competition can inspire some dangerous “panic buying” without the accompanying due diligence.

There can be some nasty and costly shocks in store such as finding out that body corporate costs may be about to blow out for required building repairs, there may be severe restrictions attached to the property or what you thought was dedicated car parking in fact doesn’t belong to the property you have purchased. These issues can seriously affect the property’s ongoing growth potential and value. The same would apply to the discovery, after you have signed the contract, that you are facing some urgent major repairs because of underlying structural problems.

Note: We make every attempt to provide answers to readers’ questions, however, answers are of a general nature only. Subscribers should seek independent professional advice for more in depth information that is specific to their situation.

Monique Wakelin is co-founder of Wakelin Property Advisory, www.wakelin.com.au, a Melbourne-based independent property acquisition and advisory company, and co-author of Streets Ahead: How to Make Money from Residential Property.

Do you have a property question for Monique Wakelin? Send an email to monique@eurekareport.com.au