The Reasons and Costs of Over-Borrowing

debt ignorance leads to poverty

The concept of debt management is especially important today as Americans are saving less and are further in debt than at any other time in our history. Why do people over-borrow and what is the ultimate cost?

Reasons for Growing Debt Level. Americans owe more and are saving less than at any other time in modern history. This slumped some during the great recession, but it has recently been reported to be on the rise again. Why do Americans borrow so much?

• Lack of Knowledge: Some people were never taught–or never learned on their own–money management skills and principles of borrowing.
• Delayed Gratification: Most people have no patience; they want to borrow to purchase things that they can’t yet afford instead of saving for them. This trait is new to the last 30 years, and never in history have people been so accustomed to constant debt usage.
• Loss of Employment: Many people have lost their jobs, and it may take them time to replace their income or they may be hired at a lower pay than they were previously earning.
• Health Bills: The cost of health insurance and health care has increasingly consumed a larger percentage of people’s budgets.
• Student Loans: Many people come out of college not just with huge student loan debt, but also with credit card debt.
• Inflation: It has been reported that inflation on average has been low (3%); however, recent increases in health care, gasoline, and food costs, as well as suburban real estate taxes, have taken a heavy toll on the middle class.
• Wages have stagnated for many people in the middle class over the past 15 years and often have not increased to keep pace with inflation.
• Inflexibility to Change Lifestyle: Instead of cutting back, some middle-income people save less, use up savings, and borrow more so that they don’t have to change their lifestyles.
• No Plan: Most people do not have an overall financial plan, including goals for savings and spending. An eFinPLAN financial plan will help you plan for your future financial goals.

The True Costs of Borrowing. The costs of borrowing are both psychological and economical. Having too much debt is a burden that squeezes family finances and increases stress. The economical costs are provided below. Think of debt as an investment. Does it make sense to borrow money, pay interest to someone else (who is profiting from you) and buy an asset that has lower value at the end of term? Or would it make more sense to save money in the bank (who loans it to someone else, giving you part of the profit by way of interest), or buy part of a company that is appreciating in value (which in essence is what stocks are)? The answers to this are obvious.

When people borrow, sometimes what is most important is the monthly payment; however, they often don’t consider the overall financial impact. If you master proper use of borrowing, you will end up being much better off than other people who have incomes similar to yours.

Tips to avoid over-borrowing: The following are excellent recommendations regarding debt and borrowing:

• Credit Cards: Get rid of most of your credit cards and pay off balances monthly. If you carry a balance, switch to a card with a lower interest rate for new purchases and transferred amounts.
• Automobile: Avoid large automobile loans; purchase used cars with money you saved. If you must borrow, keep a car for 10 years.
• Automobile Leasing: Do not use leasing 98% of the time, but if you do, don’t use it to obtain a car that costs more than you could afford if you purchased it. For example, if you could afford the purchase payment on a $25,000 car, don’t lease a $40,000 one. Look for lease “deals.” Nearly all manufacturers offer no-down-payment lease plans from time to time with very low payments in order to lower their inventory or to avoid layoffs. These lease plans can be the preferred automobile solution, but only for few people who are great negotiators. Just remember that you will have to obtain another car at the end of the lease
• Furniture, Department Store, and Appliance: These loans often have the highest interest rates (after the 90-days same as cash); if at all possible, do not take out these types of loans.
• Home Loans: We have enjoyed historically low interest rates that have allowed the purchase of very large homes. The preferred decision should be to buy a lower-cost home and to save and invest more. Instead, people have purchased homes at the very far edge of the bank’s approval amount. The larger the home, the more it costs to insure, furnish, maintain, and heat/cool. In addition, the real estate taxes are usually considerably more.
• Home Equity Loans: These can be attractive for the purchase of automobiles, home improvement and business financing, because the interest can be deductible (consult a tax adviser). However, as with all loans, consider your overall financial plan.
• Debt consolidation loans: Home Equity Loans are often marketed to consolidate credit cards and purchase depreciating goods. These are attractive because of probable tax-deductible interest and potentially lower payments. However, many people use the lower payment to go out and buy/borrow more, and then later consolidate again. This never-ending cycle increases debt and eats away at the equity in the home from appreciation.
• If in college and you don’t have a college savings account, avoid borrowing for the total cost by working part-time, applying for grants and scholarships, going to a lower-cost community college the first couple of years; but whatever you do, don’t live on student loans. I’ve known people to incur hundreds of thousands of dollars in debt. It makes more sense to take a little longer and work your way through.

This is the 2nd article in a 3-part series on debt. Please read all of these article to be a better user of it, and for ways to avoid and escape it.

1. A Basic Review of Debt
2. The Reasons and Costs of Over-borrowing
3. The Problem with Debt and How to Get Out of It