How Debt Fools People
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.