Our Love Affair with Debt

Roy S. Gilbert, JD*, CLU, ChFC

April 05, 2024

Sometimes, continuing debt seems to be a way of life for many of us. In 2023, total credit card debt in the US exceeds $1,000,000,000,000 – that’s 1 TRILLION dollars!! The average credit card APR in the 3^rd quarter 2023 was 21.19%. The average cardholder with an unpaid balance at the end of 2022 had $7,279 in credit card debt. Moreover, the total amount of credit card debt and average debt per cardholder appears to be increasing over time¹.

It is important to note that these facts don’t even include other kinds of debt such as auto loans and payday loans and mortgage debt.

Why do we have some much debt?

Although many explanations have been proffered, in my opinion they seem to boil down to two major reasons:

Unanticipated bad things happened and insufficient reserves existed to avoid debt, and
In general, “lifestyle creep” occurred where more gradually over time, expenses exceeded income and reserves were insufficient to fund the cash-flow shortfall.

What may be troublesome from a planner’s perspective is an apparent general willingness to assume debt to fund lifestyle without consideration of its long-term ramifications.

Credit card debt, for example, is often used to pay for experiences (ex. concerts and travel), consumables (ex. food) and hard assets (ex. automobiles). Using credit cards as a default method of making retail purchases, while carrying a monthly balance, may result in the debt lasting longer than the items purchased.
An auto loan finances the purchase of an asset that declines in value over time. Real estate mortgage loans are not necessarily “good debt,” but they may be “less bad” as at least they finance an asset that may be expected to increase in value over the duration of the loan.

Also troublesome is an apparent fairly common disregard of the value of an emergency reserve by those in debt. Certainly, emergency cash needs may occur and income streams may be lost, but at least in some cases, a pre-existing cash reserve might forestall a debt spiral.

What should we know about debt, in general?

It may be useful to try to categorize some of the major types of debt to which we are commonly exposed to gain a better understanding of debt:

Installment debt:
- Some examples may include mortgage loans, auto loans and student loans.
- Installment debt may be characterized by fixed payment amounts over a fixed loan term. Each installment payment may consist partly of principal and partly of interest, pursuant to an amortization schedule so that each payment reduces the amount of indebtedness².
Revolving credit:
- Some examples may include credit cards and home equity lines of credit (HELOC).
- In contrast to installment debt, revolving credit is generally characterized by ongoing access to a line of credit, up to a preapproved amount, even as payments are made against the balance due. Therefore, the amount of indebtedness may not decline as payments are made if the payments are less than any new funds accessed, and the amount of interest and fees charged on the outstanding balance³.
- Revolving credit may highlight a possible debt spiral trigger for consumers who continue make additional purchases on a credit card while carrying a monthly balance on that card.
Secured loans:
- Some examples may include auto loans and mortgage loans.
- A secured loan is generally characterized by pledging collateral for the loan. Often the collateral is the asset for which the loan was used to purchase – such as the car in an auto loan and the house in a mortgage loan⁴.
Unsecured loans:
- Where no collateral is pledged, the loan is considered unsecured. Interest rates on unsecured loans made be higher than those on secured loans as they are backed only by the borrower’s creditworthiness⁴.

Sometimes, when an urgent cash need arises, there is the temptation to tap what may appear to be a quick and easy source of money such as the short-term loans frequently seen advertised. These are often high-interest rate loans sometimes referred to as payday loans, pension advances and auto title loans. They are also often considered predatory due to excessive interest and fees and may be severely restricted or illegal in some states⁵.

How do you avoid a debt spiral?

A debt spiral may begin with a debt pile-up over time as a result of accumulating several smaller debts, possibly along with other larger ones such as mortgage loans or student loans. It may become difficult to make the monthly payments as the debts accumulate, requiring the use of savings for debt service. Eventually, it may result in an unsustainable negative cash-flow.

Preventing excessive debt, in the first instance, is certainly the most effective way to avoid the debt spiral. The first step in excessive debt avoidance is understanding what “excessive debt” means. This may then be followed by monitoring the changing levels of your debt and stress-testing the sustainability of debt service in the face of potential unanticipated costs.

Debt to income ratio - As a rule of thumb, you should try to keep your monthly debt payments to less than 43% of your gross monthly income including mortgage payments⁶.
- The maximum appropriate amount of debt to income ratio may vary for each individual based on their individual circumstances but in most cases the lower the debt to income ratio the better.
- To know whether you are within the guidelines you have set for yourself, you should measure your debt to income ratio regularly.
Cash reserve to cover temporary issues – the possibility of unplanned expenses should always be planned for. An emergency cash reserve can keep you from entering the debt spiral when unexpected expenses occur.
- The amount of cash reserve again may be different in each individual case, but three to six months living expenses as a minimum may be a good rule of thumb⁷.
- Once you have used your cash reserve, you should create a plan to rebuild it so it will remain available in the future.

How do you exit a debt spiral?

Extrication from a debt spiral may be more difficult and more painful. It involves some work in inventorying debts and other expenses and the resources available. After the income and expense assessments are completed, a repayment plan needs to be created, often resulting in some tough spending decisions.

An initial step in a repayment plan involves creating a priority order for the repayment of creditors. Do you concentrate first on the smallest debts, the oldest debts, the highest interest rate debt, past due rent or medical debts?
Next, create a plan prioritizing spending, as well as reducing expenses and potentially securing additional income. If there is any surplus income after meeting the new cash-flow plan goals, use the extra funds to further pay down debt.
Sometimes creditor accommodations can be negotiated or consolidation of debt with a new loan with better repayment provisions can be arranged.
Bankruptcy may be recommended by an attorney as a last resort where you can’t pay your bills. There are different types of bankruptcy proceedings and not all debts may be discharged through bankruptcy (ex. child support, tax claims, criminal fees among others). Bankruptcy can also impair your future ability to get credit for years⁸.

Why do we love debt so much? I don’t really know. What I do know is that for most of us, funding lifestyle through borrowing is tantamount to mortgaging the future. This may facilitate a lifelong debt spiral. Once in debt, dealing with the debt and finding a way out can seem overwhelming. If this occurs, ask for help!

In addition to assisting our clients to achieve their goals, we at the Family Wealth Decisions Group assist our clients in overcoming obstacles along the way. Avoiding and exiting a debt spiral are among the obstacles we have addressed. Please do not hesitate to contact us if you or someone you know might need help with debt. We are here to help.

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