Why Is Debt Really Decreasing?
| July 2, 2010 | Posted by Roshawn Watson under Uncategorized |
By: Roshawn Watson
In the first quarter of 2008, our debt to disposable income peaked at a staggering 131%. This means for every dollar we earned, we spent $1.31. As of March, our debt as a share of our annual income is presently 122%. If you think this change indicates that we have collectively been so scarred by the “Great Recession” that we are now behaving fiscally responsible, think again. There is a surprising and sad reason why our debt has gone down. Hint, it has nothing to do with frugality.
We Have A Debt Problem
With the macroeconomic issues, such as unemployment and recession(s), dominating the headlines, it is easy to forget that we have a culture of debt. Debt is so ingrained into our lives, it’s almost like we have a love affair with debt.
We barely even think of the true costs of our purchases anymore. We often don’t ask “how much our purchases really costs” but rather “what is the payment?” The difference between those two statements is enormous although not intuitively obvious. While the former question is concerned with the overall and long-term financial implications of the purchase, the latter focuses on how can I get “it” now. Such shortsightedness can be financially disastrous.
Whenever I hear the phrase “more affordable”, I put my hand on my wallet because the attempt to empty it will begin any moment. Almost never is that phrase used in relation to the total cost of financing. It is always used in reference to the size of the monthly payment.
In other words, this increase in affordability is achieved by prolonging our indebtedness. By spending tomorrow’s income today, we have simultaneously increased our financial risks, decreased our ability to build wealth, and probably overpaid. For example, when I purchased my first car, I was able to negotiate the price down nearly 40% because I was a cash buyer. Research shows that I’m not alone, Dunn and Bradstreet demonstrated that we spend 12-18% more when we pay by credit compared with cash.
We are permissive to debt because it is the most aggressively marketed product in our culture. By convincing us that debt is okay, marketers both decrease our inhibition to make a purchase and indirectly encourage us to spend at least 12-18% more. Make no mistake: marketers spend billions of dollars to make sure that we concentrate on payments instead of the total costs. Unfortunately, all of this marketing has worked well because we constantly buy things that we can’t afford. For example, it is quite common for us to drive cars that we really can’t afford (of course we afford the payments just fine). The cost of maintaining a car payment long-term can be measured in the millions, even if you use conservative estimates. For example, the average car payment in North America is $479 monthly. If you invested that car payment from age 25 to age 65, you would have over $2,000,000 (assuming a 9% return). It’s no wonder why finance companies want you to focus only on the short-term implications of a payments rather than the long-term impact to your overall wealth. That car in your drive way could be keeping you from becoming a millionaire! Additionally, your car payment (your liability) is their asset and is making them rich while you stay broke. Of course, we’re not just over-extended when it comes to cars. Even our housing can be at least somewhat out of control. Some 40% of homeowners are over-extended. On average, 15% of homeowners are spending at least 50% of their income on housing costs. This is a big losing battle because it is nearly impossible to get ahead financially with such huge housing expenses. It‘s recommended that we spend no more than 28% of our pretax income on housing (including insurance and taxes). Of course, credit cards, student loans, and other private loans often are even a bigger problem than housing for most people.
Falling Debt Burden
The point is it is perhaps overly optimistic and naive to think that all of this changed, even with a deep recession. We have simply drunk too much of the “a little debt is alright” kool aid. Thus, with that context, it shouldn’t come as a revelation that the real reason for the debt decline has little to do with us tightening our belts. Instead, people are making much more progress eliminating their debts by simply defaulting on mortgages and reneging on credit cards.
Some of you indicated that I was being a little to harsh a few weeks ago when we discussed
how savings had decreased while spending increased, perhaps this latest data will convince you that we haven’t mended our ways. Mark Whitehouse from WSJ argues:
Since household debt hit its peak in early 2008, banks have charged off a total of about $210 billion in mortgage and consumer loans, including credit cards. If one assumes that investors suffered at least that much in losses on similar loans that banks packaged and sold as securities (a very conservative assumption), then the total — that is, the amount of debt consumers shed through defaults — comes to much more than $400 billion.
Problem is, that’s more than the concurrent decrease in household debts, which amounts to only $372 billion, according to the Federal Reserve. That means consumers, on average, aren’t paying down their debts at all. Rather, the defaulters account for the whole decline, while the rest have actually been building up more debt straight through the worst financial crisis and recession in decades.
Despite our proclamations of frugality and austerity, old habits die hard and our actions speak way louder than words. Those actions are our savings decreased, our spending increased, our indebtedness increased or we simply defaulted on our debt and asked for someone else to foot the bill. Now if one is part of the 10% who is unemployed, then it is not surprising that things are not going well financially; he or she has an income crisis, which is a different matter entirely. However, it’s the misbehavior of the other 90% that’s really concerning. The real question is whether or not we learned anything from this financial mess? If the answer is no, then an old forewarning comes to mind.
Those who ignore history are doomed to repeat it.
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Copyright 2012, Roshawn Watson, Pharm.D., Ph.D. All Rights Reserved.
Spending tomorrow's income today, a culture of debt, and bailouts everywhere. You summed it all up perfectly. I'm afraid the only thing we've learned so far is that it's OK to take on more debt than you can ever repay because taxpayers will bail you out.At some point, however, even the bailout money runs out and reality hits us. How much longer we allow this to continue will determine how hard we get hit. I've often said that the real cause of this crisis has been a failure to fail.
I 100% agree. When is enough finally enough? There needs to be populist outrage over this disgusting behavior. This is so disheartening if you consider that we were on the verge of an awakening, but we "failed to fail" as you pointed. I hate to think of burdening future generations with our mistakes and our over consumption.
"By spending tomorrow's income today, we have simultaneously increased our financial risks, decreased our ability to build wealth, and probably overpaid."The other big impact of spending tomorrow's income today, Shawn, is that it severely constrains our financial options and ability to capitalize on better opportunities in the future. In essence, it buys a bit of freedom now in return for a life of shackles and chains later on.All the best,LenLen Penzo dot Com
Agreed. Most people use debt unwisely. Debt is bondage. People don't realize that it most often is that simple. I rather someone call me unsophisticated (because I don't espouse debt leverage) than broke any day of the week.
The country is a mess fiscally along with the majority of Americans. Quite a shame that no one display self control.
Yeah, with $13 Trillion in debt, our country's finances highlights poor fiscal decisions. This is what happens when we have such a permissive view of debt. It's quite sad indeed and must stop. Regards,Shawn
Ah yes "affordability". I like it where on the Home Shopping Network they're pushing some product for "only" $99 and then you look closer and it's 3 payments of $99 !Maybe its just a math issue. Maybe people (including politicians) don't know that 3 payments of $99 is more than 1 payment of $99.Hey…the Joneses borrow to buy the biggest car in the neighborhood and then the neighborhood borrows to keep up with the Joneses!
Agreed. The Joneses are very broke! The affordability issue is just darn aggravating. You almost never be able to truly "afford" anything as long as you keep committing tomorrow's income for today's pleasures!
Loved the analogy about investing car payment at 9% to save 1 million! Great concept. Best regards, Barb
Yeah, over 40 years, a car payment can be over $2 million. No car is worth that to me. That's why it's an easy decision for me to say no to car payments.Regards, Shawn
Along DIYInvestor's train of thought, there is now a commercial on TV that offers a "gold coin for only $9.99 a month." There's no mention of how many months, or total price, no website or company name where you can find or research that info. It's very sketchy, but I wonder how many people fall for it. At least whatever is being sold on HSN presumably can be used for something.
One of my pet peeves is car ads that only list the monthly payment; not the price.Sadly, it works. One of my family members goal when buying a car is to have a low monthly payment. My last new car I went for the highest monthly payment I could afford. It's paid off and I don't plan to get a car loan ever again.
Anonymous, the case that DIY Investor mentioned is very sketchy indeed, but under the guise of affordability we often get sucked in. The sad thing is if we just slowed down a little, we could easily figure out that it is a scam (or at least not smart). Unfortunately, there are still people falling for the Nigerian scheme and phishing as well. It's sad!
@Bucksome,I'm with you on that car payment. I never plan to get another one… ever! In fact, I'm also through with consumer debt entirely. The years that I have been debt free (excl. house) have been some of the most peaceful and prosperous years of my life, and I don't every intend to go back. There's nothing that I want that badly. I completely share your resolve.
This is a very good read! I certainly hope that people have learned some lessons – at least a certain percentage, anyway. I have to belive that many of us who blog on these topics tend be more aware of personal finance principles than a large percentage of the rest of the population. Thus, while we think about such things, many in that group might not. The result: lessons will not be learned by many people.Additionally, those who are young now, but will be in the workforce in 10 to 15 years, will have their own experiences to draw upon. What will they have learned from our recent travails?So have we learned anything from this mess? As a society – I believe we have somewhat, but just how sticky that impact is remains to be seen. As individuals – some will learn, many others won't.Very good post and discussion.
@Squirrelers I'm sure some individuals did learn their lessons. The ones who went through the most pain and the ones smart enough to learn from others' pain as well. I'm amongst the second group (not b/c I'm so smart but because I really dislike pain). Anyway, the problem is overall, we haven't mended our ways, which is very disturbing. This is very different from the Great Depression, where there was truly generational imprinting of thrift. People really did become more frugal, and those habits remained for years. With such a "scary" economic event, it's sad that the stats are so poor. Another relevant issue is the Great Depression was so much worse than this recession. So many more banks and businesses closed, and there were literally bread lines during the GD. It's not really a fair comparison, but since it's one that people will constantly make, I bring it up.Regards,Shawn
Great, wonderful post! I'm constantly amazed at people who consistently spend more than they make. And then complain they're in debt! As to your question, I'm not sure if people have learned anything from this or not. In my opinion, too many people are blaming their personal tough times on the economy and not prior/current spending habits. Jenniep.s. found your article via joetaxpayer.com, in case you keep track of such things.
Jenni, You bring up a very interesting point. Who is the real cause of the tough times? For example, if you have been very conservative, avoid debt, have adequate liquidity, and built both retirement and non-retirement wealth, and the economy went bad, sure you need to avoid being reckless, but you might actually be doing better. This is considering that you weren't one of those who lost her job. You may be doing better because there are all sorts of deals (investments, mortgage interest rates, consumer goods etc). Warren Buffet said be greedy when others are careful and careful when others are greedy. People are reluctant to point the finger at themselves because it's a) hard to deal with the fact that they screwed up their lives (or had extremely bad fortune… i.e. horrible sickness)and b) they have no desire to change. However, owning your mistakes is empowering because we really CAN control ourselves. When I realized that I was making stupid decisions, I changed!Thanks so much for stopping by and thanks for letting me know that I was in Joe's round up!