How Debt Fools People

by Philip Brewer on 11 January 2010 19 comments

People who have a natural aversion to debt often wonder how some people get themselves into such terrible problems with debt. Don't they know how much it costs? Don't they understand they can't just go on boosting their standard of living through ever-increasing levels of debt? But that's not really how it happens. As a public service, here's a worked example of how debt spirals get started.

Suppose: Two neighbors are debt-free. Both want a new TV that will cost $500. Money is a little tight — each one only has about $50 a month available in the budget.

One saves for a TV. He puts $49.76 into a high-yield savings account paying 1.3% interest. After 10 months he has $500 and buys a new TV.

The other borrows to buy the TV. He takes out a $500 loan at 11% interest, makes payments of $52.56 and pays off the loan in 10 months.

At the end of ten months both people have a TV. The guy who borrowed the money paid a total of $28 more than the guy who saved, but he got his TV 10 months earlier. You could look at it as if he paid $28 to rent a TV for 10 months. That's a nice boost in standard of living that someone could reasonably view as being well worth the money.

The debt-averse people suppose that a classic debt spiral starts when you extend this logic beyond a single time-limited purchase: A couple months after buying the TV you decide to buy a recliner — after all, now that you're spending so much time in front of your TV you want a nicer chair to sit in. In this scenario the foolish borrower encumbers every available dollar in the budget with payments on more and more stuff until he or she can no longer make the monthly payments.

I'm sure that happens to some people, but I don't think it's the most common scenario that gets people into trouble with debt.

The reality of debt spirals is more insidious. It results from the loss of flexibility when a household incurs a perfectly reasonable amount of debt — or even no debt at all, but some amount of fixed monthly expenses — and then suffers a negative economic event such as a large unplanned expense or a drop in income.

Because that's the way that debt really works its harm. It's not that it costs so much money (although it can), nor is it people obligating themselves beyond their means (although some do). It's that it makes the household finances so much less flexible. It's not the extra $28, it's the inability to adapt.

To the saver, a spike in fuel costs means cutting back on saving in order to put enough gas in tank to get to work every day. To the borrower it means either not being able to get to work or borrowing money he can't pay back.

The reason debt fools people is that even when the cost of the debt is perfectly reasonable, the lost flexibility means any little problem can kick off a debt spiral.

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Guest's picture

A lot of the fooling comes from cultural cues as well. Unlike a generation ago, debt is no longer viewed as something to get out of, but rather as a gentle enabler to get us what we want.

The media/marketing geniuses get us focused on what debt buys for us, rather than the burden we'll carry, or the havoc it can wreak. Debt is a lot easier to get into and maintain when it's viewed somehow as being normal.

Look at the "I owe, I owe, so off to work I go" bumber stickers; they're cute at first glance, but what they really convey is a message of resignation. A debtor seeing the sticker might think, "hey he's just like me, I guess I'm not the only one". That's reinforcing a negative in a real sense.

Guest's picture
JustAGuy

I do love it here up on my high horse. I am debt free and have always assumed it was habitual overspending that caused other's debt woes. I'd be interested to see for what percentage of debtors this is the case (Hard numbers not my own or someone else's bias). Anyways, your post here made it very clear what a tricky game this really is.

I think with this straightforward example you should land yourself on every morning talk show, the Dave Ramsey show etc. Too bad you don't have a book to sell - yet.

Good luck.

Guest's picture
Ben

Being debt averse, I never thought of accumulating debt because of the 'debt spiral.'

One thing I have noticed is that the options for debt averse savers are decreasing while the options for financing spenders is increasing (aside from the federal credit card legislation that recently took affect).

Numerous stores, for example, that used to have layaway no longer off this service.

On the other hand, financing options have ballooned.

This is one example of how shopping today is more difficult for the saver than the financer, which also contributes to debt.

Guest's picture
Paul

Articles like this are why I subscribe to your RSS feed! I know I have a tendency to minimise the risk of buying on credit, I tell myself it's just a one-off purchase but before I pay it off low and behold another 'one-off' comes along.

Reminders like this to weigh up all the pro's and cons are very welcome, thanks :)

Guest's picture
2 Cents

I always thought my debt aversion came from a fear of becoming over-extended, but if I really think about it, it really is the lack of flexibility that I hate more than anything. The constant feeling of something hanging over my head and fear that a change in income would lead to serious trouble make me want to get rid of all of our debt once and for all.

Actually, we did experience a drastic income reduction last year, but we did OK thanks to my paranoia. We have only a modest amount of debt left. There's only the mortgage, and it's much smaller than it used to be!

I agree with those here who point to huge changes in the way debt is offered to us as at least part of the reason for the recent debt epidemic.

Julie Rains's picture

Wow -- great article. I always had the sense that there was something wrong with the interest-rates-are-low-buy-more argument but won't say that I could ever define or articulate this idea the way you have. From a job-search standpoint, a problem with not being flexible is that you can't take a so-so job now to ride out the recession but may need to make a certain amount just to pay monthly bills.

Guest's picture
Tony Smit

This article does not mention the ugly effect of the payday-loan and quick-short-loan financial businesses. Their fees are very high, the interest rates are very high. These businesses drain the money from a person's life very quickly leaving them unable to afford to keep up with their needs.

Philip Brewer's picture

Payday loan places are a pernicious blight.  When a title cash place moved into my neighborhood I said that I might have preferred a brothel or opium den.

Even so, I doubt payday loans are really the breaking point for most people.  Rather, people only take out a payday loan when their finances are already broken.

Nobody starts by seeking credit from a payday loan place--they resort to a payday loan when all other sources of credit have been cut off.  If you're three months behind on your power bill, even the high interest on a payday loan may be cheaper than paying reconnect fees after your power has been cut off.  But the problem that broke your finances is whatever brought you to such terrible straits in the first place.  The payday loan is just a nearly always doomed effort to stave off complete collapse.

Guest's picture
Matt

@Ben - for large-item retail outlets (ie. Best Buy, Future Shop, car dealerships), financing or in-house credit cards is where they make most of their money. They only make a slim profit on the actual item if you pay cash.

Guest's picture

Excellent post. Also, I don't think $28.00 represents the full interest cost. If someone puts the tv on a credit card and doesn't pay in full, interest is assessed on all new purchases 9you lose your grace period). Then, if the payment is late, you're assessed another fee.

Guest's picture
Cedric von Monkey

Great article...dovetails nicely with the broader goal of having as many options in life as possible....in this case, if you are living below your means or savings cushion, a setback such as a big expense or loss of job does not set off a spiral....you retain more options.

Guest's picture
Guest

Having experienced this exact same 'debt spiral' intimately, I really appreciate the article.
I wish someone had sat me down and explained it to me in college - or even high school in just these words.
I'm debt free (except for the mortgage) now and will never go back to credit card use that isn't paid off in full every month.

Guest's picture

Philip, another great article. I think to add to this, I would say that people often take their monthly payments right up to their income, a little below, or a little above. As you indicate, when something bad happens, which it always does, they don't have any cushion. That may set off a change in their terms or their terms may change on their own. For instance, many credit card companies increased minimum payments from 2.5% to 5.0%. That kind of shock when you have no savings creates the downward spiral. If you opt for one of those no interest consumer retail plans and something bad happens and fail to make 1 payment, you suddenly have a huge increase in the amount that is owed.

We have to realize that by and large, we have been in an environment where most of the factors have gone the other way over the last 20 years. Tax rates went down, mortgage rates dropped, and credit card rates dropped. All these factors ended up lowering monthly costs and allowing people to get out of jam after jam. But in the last two years, its heading in the opposite direction which will mean more people getting caught in the debt spiral.

The problem again is that if you don't have a savings cushion and are spending up to your full income you are almost certain to run into trouble.

Philip Brewer's picture

 @LiveCheap:

Right.  I wrote a whole post about variable terms, which is one way minor problems turn into catastrophes.  But your point—that the past twenty years have seen debtors repeatedly bailed out by declining rates—is a very important one.  We have a whole generation of people whose experience is that falling rates and falling taxes will bail them out if they get a little over their heads.  Most of them are going to find the next 20 years very different—and very painful.

Guest's picture
Beth

I love this way of understanding the debt spiral. It seems a much more *useful* perspective on household finances than the usual.

Guest's picture
Ash

Phillip, your posts are the best. I love the way you summed it up. I'm a freelancer who's been writing a lot about credit cards recently, and all the research shows that nobody plans to get in over their heads - it happens through mistakes.
Credit card example - if you miss the date by one day (here in Oz) you are charged about $50 in fees and interest on a monthly spend of $1300 because the "interest free days" disappear and interest is back-calculated. Banks profit off people making mistakes. Imagine if you really couldn't pay the bill one month.

And that's the thing: everything is reasonable, until a disaster happens.

Love your succinct way of putting it.

Guest's picture
Gino

I know what its like to get caught in a spiral. It can be hard to get out of too. Self proposed needs seem to overrule logic. There are people who can help though. Budgeting is important and there are companies such as this one that can help.

Guest's picture
mj34232

Great article. I finally came to realize also that the 6- and 12-month no interest on store credit cards fools one. Last year I took advantage of one of the big box promos and bought a more expensive dishwasher than I would have if I had been paying cash. I split the cost into 5 payments because I never let it accrue interest, but 1 month into it my cat became ill and I had to have a new crown ($1,500) and these were not planned expenses. It made it very tough to keep paying the monthly on the 'interest-free' loan but I did it. I will never do it again.

Guest's picture
Guest

I never thought of it that way. Now, it seems totally obvious, but it's never been presented to me as this contrast between this story we believe about debt, and the reality that we've all seen happen to people.