How much of your money is yours and how much you pay toward your debt has a lot to do with how your debt got there in the first place. There are several reasons we accumulate debt, like paying for unforeseen emergencies or unemployment. But most often, debt is a result of bad spending habits, because unless you're spending cash, it's costing you money to spend money.
Imagine a credit card is someone granting you a favor to buy something you can't afford now but can easily pay off in the future. Well, the reality is that you simply end up owing more and owning less. We have been talking about the Joneses -- those neighbors with the life and stuff we want -- for almost 100 years, and we still can't keep up with them. Unfortunately, never being content with what we have can lead to large amounts of debt. And lacking the knowledge we need to manage that debt can keep those credit card balances static, or worse, allow them to grow.
Here's how. Imagine making a credit card purchase for $500. You rationalize spending the money because you look at it in $15 payments that are completely manageable. But what you don't see is the lender standing next to you with an outstretched hand wanting an additional $147 in interest charges. At $15 per month, it will take you four years to pay off the new $500 item at the average 2010 interest rate of 14.7 percent [source: Simon]. Considering that many credit cards have higher interest rates, this same purchase at 22 percent, for example, means handing over an additional $280 to the credit card company. Sure, you'll have four whole years to pay the $780, but will the item seem worth it when you finally own it outright?
Add to the small "wants" of our lives the larger investments of financed homes and cars, the planned "musts," such as college costs and weddings, and possible unplanned medical emergencies, unemployment and relocation, and it's easy to see how debt grows.
The No. 1 reason people go into debt is one or a combination of these factors, but it will include both personal finances and impersonal financials.
Next, we'll visit the debts of spending past, spending present and spending yet to come.
Spending More Than You Make
If you live in the United States and spend more than you make, you're part of the norm. More than 40 percent of Americans spend more than they make, leading to a debt-centered financial life [source: Khan]. Spending more than what you make sells your income to the future. Without a plan to catch up to the cost of the money you've already spent, your debt will accumulate more debt through interest.
Living month-to-month also creates a situation where you have nothing to fall back on if money runs out. And unfortunately, this over-spending lifestyle perpetuates the myth that we'll catch up on our debt in the future, keeping us in exactly the same situation year after year.
But spending less than your salary has never been the model that most people grow up with in the modern world, even though saving up and paying cash keeps us better positioned for the future. Your monthly income should be dedicated to future planning and present comforts, and you should pay money into your savings to reach goals and achieve whatever amount of financial security you desire.
However, even the most disciplined and creditor-savvy consumers can fall into debt in the blink of an eye. While over-spending isn't the issue for everyone, personal emergencies touch households daily. Financial advisors generally recommend a savings of at least six months or more to cover costs for emergencies, but with an average of less than 6 percent of U.S. incomes going into savings, most emergencies have to be financed [source: U.S. Dept. of Commerce].
While your personal debt belongs to you, get to know your impersonal financial partners, next.
As much as it helps to see financial institutions as the bullies behind our debt woes, there is two-part accountability in debt creation. We have to take personal control for our own spending, but the lenders also have a form of impersonal control that can help or hinder us.
In the simplest terms, most worldwide economies need consumers to spend money for the health of the economy, and banks and other lenders facilitate that spending. Individuals with good credit histories can borrow at lower interest rates because they are less of a risk for defaulting. Those with bad credit will get loans at considerably higher interest rates. They get a bigger hole of debt and have an increasingly smaller shovel of resources for filling it up. But having good credit can be a detriment. If a lender sees you as a low risk borrower because you have good credit, you could be more of a target for low-interest offers on lines of credit.
Why? Because according to a 2009 U.S. Census Report "the number of people in poverty in 2009 is the largest number in the 51 years for which poverty estimates are available" [source: U.S. Census Bureau].That means many of the 43.6 million people in poverty owe lenders and can't pay them. Financial institutions need to offset the losses, and they're watching and marketing to those customers that can.
Regulations have been put in place to make lenders more accountable to bad lending practices. The Truth and Lending protections of the Federal Reserve in the United States and similar consumer credit legislation in Europe and Japan now require creditors to state all fee and interest terms, and they must notify consumers in advance of any increases. Some of these laws even place limits on the interest financers can charge. Marketing for loans still creates spending, and credit cards are still looking good with fine-printed terms to confuse the simpler reality of what they are, but full disclosures are there. Buyers just need to read them.
Creditors are, after all, for-profit businesses. Helping borrowers stay out of debt is not the business of lenders who earn from our debt. While banks and financing play a large, and often healthy, role in economies, if a person's finances are debt-heavy, doing whatever it takes to get out of debt requires discipline and creativity in small partnership with the money lenders.
Ready to bank some knowledge on how to get out of debt? See the next page for budget resources and calculators.
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