The "Two Income" Trap

Overview:

Two children, two incomes, a home with a white picket fence; it's the quintessential American Dream. However, this American Dream has morphed into a survival regimen that many families simply cannot endure.

Parents are in worse economic shape than ever before. Married couples with children are twice as likely as childless couples to file bankruptcy. Having a child is the best indicator of whether someone will end up in financial collapse, according to the authors of recently published book, "The Two Income Trap," by Elizabeth Warren and Amelia Tyagi, a mother and daughter team (Harvard law professor and MBA) who did an extensive study on the nature of bankruptcy in America.

The authors maintain that the introduction of mothers into the workforce, rather than easing the financial strain of raising a family, sets their families up for financial disaster as the cost of raising children spirals out of control. More children will go through their parents' bankruptcy than their parents' divorce. One in seven middle-class families will file bankruptcy by 2010 . These figures are staggering for middle class families.

At first glance, that argument seems counterintuitive. Two incomes ought to create a larger financial cushion than a single income. The modern two-earner family brings in 75% more inflation-adjusted income than the traditional one-income family. Yet, families today have less discretionary income than the traditional one-income families for a variety of reasons.

The decline of public education has raised housing costs in good school districts, prompting parents to overextend on mortgages. Couples with children are spending more on housing than ever before. At the same time, the free-wheeling, unregulated lending industry resembles a carnival sideshow with lenders assuming the role of "carnival barkers;" step-right-up folks we'll finance 120% of the purchase price of that home for 3% down. Families are spending themselves into financial collapse. The lending has industry has buried American mailboxes in a tsunami of 5 billion pre-approved credit card offers in 2003.

This perilous situation is compounded by the fact that married couples with children work in an era of unprecedented job insecurity, where employers regularly slash salaries and insurance benefits. The rates of the medically uninsured are increasing, the cost of healthcare is through the roof and families are more likely to be caring for elderly parents. In fact, nearly 90% of families with children who file bankruptcy cite three reasons: job loss, medical problems, or divorce, according to the Harvard University Consumer Bankruptcy Project.

Having children is a leap of faith, rather than a cold, hard economic calculation. However, many families may not have the financial capacity to land safely on the other side.

Some Cold Hard Facts:

In 2004, more women will file for bankruptcy than will graduate from college. In 2004, more children will live through their parents' bankruptcy than their parents' divorce. Seventy percent (70%) of all Americans say they are carrying so much debt that it is making their  home lives unhappy.

So....What Can You Do?

Here is a quick summary of the information and advice contained in the book (with some additional information and advice sprinkled in). First...you need to get a handle on how most people get into financial trouble.

How most people get into financial trouble:

    They have kids, and try to provide a safe environment for them to grow up in where they can also get a good education. This usually means buying a house in the suburbs, but suburban housing prices have gone up so fast that families have to send both parents to work in order to be able to afford a good house. Even then, their salaries are stretched thin.

    Some sort of crisis usually pushes a family over the edge into debt. Medical emergencies that result in large medical bills or force one working parent to quit and provide home care are a common trigger. The layoff of one parent is another common trigger. Divorce and the increased cost it necessitates are a third common reason for families to fall behind on debt payments.

    Rather than shying away from families in financial trouble, financial institutions descend on them like vultures, offering second mortgages and credit cards with extremely high interest rates and late fee schedules. The high interest rates and excessive fees more than make up for high collection costs and default rates. For most big banks and retailers, high-risk customers are their biggest source of profits. Distressed families tend to accept these offers as a short-term solution for what often ends up becoming long-term problems. Before they know it, families end up buried under a mountain of debt, and constantly dealing with harassment from repo men and bill collectors.

A summary of what people should do before they get into trouble:

    Consider keeping one parent home. If the working parent gets laid off both parents can look for work. Keeping one parent at home also saves on a wide range of costs and the second salary is taxed much more than the first.

    Downsize fixed costs. People who are stretched thin during ordinary times are just one unexpected crisis away from a financial meltdown. Understanding that medical emergencies, layoffs, divorces, etc. happen, it is important to leave some wiggle room after the fixed costs. In an emergency it is much easier to cut back on luxuries, so cutting back on housing, auto and education expenses is a better way to give your family an insurance buffer than cutting back on the entertainment and recreation budgets. Don't buy a house that you can't afford. Just because a bank is willing to loan you the money, doesn't mean you can afford it. Many banks engage in a practice of "loan to own" whereby they offer sub-prime mortgages they know will cause their customers great pain. They collect huge profits on the interest as long as the homeowner can struggle to make the payments and then make a bigger profit on the house once the loan goes into default and the bank forecloses. If you can't put 20% down you probably shouldn't buy the house. If the bank is only willing to offer a sub-prime rate, don't take it.

    Have a backup plan in place. Know what costs you can cut in advance and where you will search for added income if a crisis interrupts your current situation.

    Put some money aside in savings. Just don't count on the stock and bond markets or other real estate investments. Those tend to go bad when the most people are experiencing financial crisis.

Want more facts?

More than 1.5 million American families declared bankruptcy last year. More than 18 million families would have been better off financially if they had declared bankruptcy, but out of a sense of responsibility, pride, stubbornness or ignorance continued to try and pay their bills.
    
In bankruptcy the filing family gets to hang onto its home, but most other debts get wiped clean.
Bankruptcy is still a major pain and an embarrassment with long lasting repercussions.
An individual can't declare bankruptcy more than once in a 7 year period.

The biggest reason for the rise in debt between 1980 and 2004 was the effective elimination of usury laws that resulted from a US Supreme Court decision in 1978. Before then, states could effectively limit predatory lending practices that took advantage of distressed and mathematically challenged consumers (similar to the way heroine and crack dealers take advantage of addicts). After the decision, banks incorporated in South Dakota and Delaware could charge very high interest rates and they rushed to make loans to people that pushed them into deep levels of indebtedness that led to deep reductions in their standard of living.

Lastly, advice for people already in DEEP financial trouble:

Avoid the blame game. Around 90% of families get in trouble because something bad happened to them. Financial stress can lead to serious domestic problems, which can lead to much more financial stress. Sure, we all have responsibilities to our creditors, but our responsibilities to our children and families are a higher priority.

Decide which financial assets are most important and pay for those first. The house? The car? Health insurance when you have an existing medical condition? Calls from collectors will be extremely annoying, but it is not cost effective for creditors to actually reposes goods. If you pay for too many of the non-essentials, you may end up losing the essentials.

Don't get suckered into consolidating your debt. Financial institutions will offer to let you roll over your debts into second mortgages. However, you need to have a realistic eye on the possibility of bankruptcy. Once you get out of bankruptcy, you will have a much larger and more expensive debt burden on the house and will be more likely to lose it if you consolidated those debts.

Don't declare bankruptcy until the financial crisis is over. The collectors will harass you in every way imaginable, but eventually many of them will give up on collecting because that is the cheapest route for them. Meanwhile, most financial crisis will go on longer than the family expects. If you declare bankruptcy before it is over, you'll fall right back into debt without the ability to declare bankruptcy again for another7 years.