As a follow-up to my Wednesday post ( Why are banks so generous?) on mortgages - specifically, why lenders seem to be in the habit of giving larger-than-asked-for amounts of money - the reason behind the practice is actually pretty clear: Banks make money on the loans, so the bigger the loan, the bigger the profit.
The part that gets to me is that this recently got U.S. lending institutions -- not to mention the global economy -- into a lot of trouble. Many of the comments on my blog post suggested that banks take a buyer-beware approach. That is, they can't possibly know about your aspirations for producing children or taking vacations, so they don't take these factors into account when deciding the size of mortgage they're willing to give you. What's deemed to be a prudent mortgage is up to you.
But the buyer-beware approach doesn't always work, especially when the economy turns against home-owners and unemployment rises. It also doesn't work when the level of financial knowledge among consumers isn't that high. James Surowiecki, at The New Yorker, recently wrote about this sad state of affairs in the United States, and it probably applies equally well to Canada.
"The depth of our financial ignorance is startling," he wrote. "In recent years, Annamaria Lusardi, an economist at Dartmouth and the head of the Financial Literacy Center, has conducted extensive studies of what Americans know about finance. It's depressing work. Almost half of those surveyed couldn't answer two questions about inflation and interest rates correctly, and slightly more sophisticated topics baffle a majority of people. Many people don't know the terms of their mortgage or the interest rate they're paying. And, at a time when we're borrowing more than ever, most Americans can't explain what compound interest is."
David Berman