Have you ever wondered how and why people get into debt? And what really triggers the financial challenges we have all faced at some time. We know that debt can lead to disastrous consequences; it can destroy a relationship, lose our assets and everything we have worked so hard to create, and it can bring on mental anguish like no other problem previously faced.
So why would anyone take the chance and incur debt? Truth is there are any number of reasons people take on debt, some within our control and some outside our control, some are choices we make and others are driven by circumstance.
It is important to understand how we can become consumed by debt so we can recognize the warning signs and attempt to avoid entering the debt cycle.
To understand debt, it is important to understand the debt cycle. The debt cycle usually begins when we start to live beyond our means and spending becomes greater than net income. This can happen for a number of reasons from ignorance to absolute necessity.
Anytime expenses are greater than net income it means we must borrow to maintain our current lifestyle. This is fueled by the ease in which credit is available to us and by all the options available to us that make using credit as convenient as possible for every day expenses. This usually starts by adding small purchases to existing credit cards to get through to the next pay day, always with the intention this will be paid off as soon as the next pay day arrives. The fixed or non-discretionary expenses we have cannot be easily changed so the only way to make the required payment to the new debt is to change our lifestyle. It is important to remember our non-discretionary expenses are also driven by life style and choice, the area we live, the house we live in, the cars we drive, etc.
Once in the debt cycle we soon find that the plan to pay off the small debt we incurred is not achievable and then before we know it we have borrowed to the available limit on the first credit card. This quickly follows with obtaining another credit card or credit facility. This is often spurred by the 0% interest balance transfer with the mindset that the debt will be paid down much faster at 0% interest. What we don't always realize is the 0% interest is on the balance transferred but any new usage will incur the standard credit card rate and any funds deposited to the card go against the new purchases not the balance transfer, this means that the introductory 0% rate period is quickly passed and limited progress has been made to pay down the debt. Now the full interest once again is being charged on the existing balance plus the new debt you have incurred. Instead of one credit card, we now have two and more available credit, and the spending continues, digging ourselves deeper and deeper into debt each month and the cycle continues with limited opportunity to escape.
Once we enter the debt cycle it is very difficult to get out of and usually requires a life changing event such as a financial windfall or a significant change in life style.
There are many reasons why people accumulate debt:
- Poor money management - It can be hard to understand interest and what it truly costs. Usually inadequate budgeting leads to incurring debt. Without a proper budget you cannot track your expenses. If you write down everything you are spending for an entire month you can see exactly where your money ends up and see where changes can easily be made, this is the best way to learn where you can cut unnecessary expenses and help yourself avoid debt.
- Compulsiveness - Some people lack the self-control and discipline with their spending. Others may not want to control their spending, but the time will come when we will all be held accountable for our spending and the choices we have made.
- Pride - People worry more and more about the social circles they move in and how they are perceived by their neighbors, friends and family and this can drive how we spend money and incur debt to maintain a false perception of their financial situation.
- Necessity - People go into debt in order to simply survive and provide the basic needs of food and shelter for their family. Necessity is rarely the only reason people go into debt and this usually precedes one or a combination of the other factors listed.
- Reduced Income - This can immediately lead to expenses exceeding income. The danger is when it is viewed as a short term set back and normality will quickly return and no lifestyle changes are made (often driven by pride). Immediate action is needed to make sure that you understand what your change in income means so you can create a budget and plan to allow for this. Hopefully the reduced income is temporary and the changes in lifestyle and spending is managed early without using credit to subsidize a lifestyle during this period as it can become extremely dangerous.
- Divorce - More than half of Canadian marriages end up in divorce and this can be driven by or create immense strain on personal finances.
- Gambling - Is an increasing form of entertainment and with the evolution of online gaming it is becoming more prevalent and easily funded through credit cards. It becomes easily addictive with the idea of "The big win" or the mentality I will just win back what I lost, and then I will stop.
- Limited Savings - To avoid unwanted debt we need to be prepared for emergency expenses. If you have sufficient savings you are not reliant on easy to access, short term, and high interest credit to meet the unexpected bills. This also creates a comfort zone for severe illness, job-loss, divorce or other life altering events without incurring debt.
Any of the above scenarios make it very easy and also common for us to incur debt. However, if you develop good money management and budgeting skills before any of these events take place it will make it much easier to deal with them, and ultimately avoid them in the future. Any time we spend outside of our means it will reduce wealth, and put us at financial risk. By taking the necessary steps toward financial responsibility you will greatly reduce the probability of entering the debt cycle.