Yesterday I began a series of posts which attempts to explain why the working poor tend to make terrible financial decisions and how they think about money differently than other economic classes. In my initial post I wrote,
Imagine that instead of having to deal with consumption smoothing decisions, at most, several times a year, you had to deal with them several times a month, or even several times a week. Now also imagine there is no workable solution that will actually smooth the short-term consumption problem and the best that you can hoped for is a temporary fix that delays having to deal with the issue.
That is what it’s like to be the working poor.
Several people have asked me to explain more what I meant, so before moving on I wanted to provide a more in depth example.
Let’s again begin by looking at the decision-making process of the middle-class. Imagine that you want to buy a home. Your household income is $51,404 a year (the median household income in the U.S.) and the house you’re interested in is on the market for $152,000 (the avg. home price in the U.S.). At what point do you buy the house?
There are several ways the average American may answer, but the one response you will almost never hear is, “You should buy the house only after you’ve saved the $152,000 needed to pay for it.”
While most people would agree that it would be prudent to apply a down payment, the idea that you’d pay the entire amount at once – even if you had $152,000 in cash – would strike most people as peculiar if not absurd. Instead, we borrow money for a mortgage that will allow us to pay a set amount each month for 15 to 30 years. Because we are willing to spread our payments out into the future we will pay a lot more than the $152,000 (at 5% for 30 years, the total would be $293,748.79). But we consider that a reasonable accommodation for getting what we want right now.
That is an example of how most of us take the concept of consumption smoothing for granted.
Notice that the assumption behind the mortgage is that your household income is likely to remain the same or increase. Either way, your income has crossed a threshold that allows you to consume a good today (i.e., you get to live in the house) and pay for it later based on your future earnings.
Take a look at the monthly expenditures for the average middle-class family. Aside from the basic necessities, such as food and utilities, you’ll find that many of the payments are related to consumption smoothing: mortgage, car payment, student loan repayment, credit cards bills, insurance (e.g., car, health), contribution to savings, contribution to 401K, college fund, etc. Most of the income the middle-class earns each month is used to repay what we consumed in the past or to save so that we may consume more in the future.
This is one of the main differences between the middle-class and the working poor. For the middle class, the ability to apply consumption smoothing makes life easier, less risky, and more enjoyable. For the working poor, the inability to apply consumption smoothing makes life much more difficult. In fact, the four main economic problems of the working poor are related to consumption smoothing.
The first, and most obvious, problem is that the working poor often do not have enough current income to cover expenses. The second, an even more significant type of problem, is that they are not likely to earn enough money in the future, which limits their ability to use credit. The third problem is that for the working poor the timeframe for the “future” is much shorter than it is for the wealthy and the middle class. And the fourth problem is that being poor is very expensive lifestyle.
Here’s an example of how these four factors affect the working poor. Tom lives in a rural area and relies on his 2008 Dodge Neon to get him to his full-time minimum-wage job. He knows he needs to replace several worn engine parts but he currently doesn’t have the money to buy what is needed (Type #1). After a few weeks, the car ceases to run at all and the repairs will cost him $500 (the equivalent to a week and a half of pre-tax wages). Because of his low wages and late payments, he has a low credit score making it impossible to get credit at a reasonable interest rate (Type #2).
To get the $500 for the repairs, Tom decides to seek help from a payday loan service. The finance charge to borrow $100 ranges from $15 to $30 for two-week loans, so let’s say Tom pays the minimum rate. After two weeks, his total repayment will be $650, an APR of 782.14% (Type #4). Obviously, since Tom does not have $500 today he is not going to have $650 in two weeks (Type #2 and #3).
He can’t afford the payday loan, so he can’t fix his car. But if he can’t fix his car he can’t go to work. And if can’t go to work he’ll lose his job and be unable to support his family or pay his bills. What should Tom do?
Our first reaction may be to wonder why he’s in this situation. We might even have justifiable reasons to chastise Tom for the decisions that lead to his being in such dire straits. Maybe if he had studied harder in school he’d have a better job. Or maybe if he hadn’t been late paying his electric bill he’d have been able to get a credit card. Most likely both a combination of poor individual choices and systemic constraints outside of his control brought on his present crisis.
But if we set aside our critique of Tom and look only at how he would help him resolve the problem, we begin to understand and appreciate the complexity and difficulty of finding a solution. Once you get caught up in working poor problems, it’s exceedingly difficult to find a way out.
Tom’s range of options is likely to be, at best, suboptimal and, from the perspective of the middle-class, completely irrational. But what we don’t see is that this is not the first consumption smoothing problem Tom will face this year or even this month. For the working poor, these types of crises come all too frequently. Attempting to deal with them while faced with overwhelming financial constraints can alter the way the poor view finances. That’s the issue we’ll turn to next.
In part three of this series we’ll look at some of the specific ways that these constraints affect the thinking of the working poor and their relationship to money.