Investopedia/Lisa Smith: How People Fall Into a Debt Spiral

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How People Fall Into a Debt Spiral

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By Lisa Smith
Updated Jul 16, 2018

The world is awash in a sea of debt. People, companies and even nations are caught in a borrow-and-spend cycle that results in ever-increasing  loads. For consumers, the path to insolvency often begins at a young age as they grow up witnessing their parents struggle with money and paying off the mortgage or other loans. An endless stream of advertising ("Low credit? No credit? No problem!") reinforces the idea that everyone has debt and that buying on credit is a normal and acceptable activity.
Higher Education, Higher Debt

For young people, the slippery slope continues when they pursue higher education. Since paying for college or a technical training in cash is unfeasible for many people, education loans are the only choice. Unfortunatey, taking out a loan immediately puts your balance sheet in a bad position. You are accumulating debt at a time when you probably do not have enough income to make even a single payment in an effort to reduce the debt balance while you are in school.

Credit cards soon come into play to help you cover the daily costs of living. While your loans are accruing interest and putting you deeper in debt, credit cards up the ante by charging significantly higher rates of interest than what you already owe on the school loans.

Debt spending is further reinforced when you finish school and need a car so that you can hunt for a job or commute to work. This results in a visit to the auto dealer, where you will find yourself confronted by a salesman who cheerfully asks: "What size monthly payment are you looking for?" By the time you leave the dealership, another debt has been added to your burden. Your school loans, credit cards and auto loan are all working hard to eat into the earnings from your new-found job.

A home mortgage comes next. Soon thereafter, the percentage of income dedicated to making monthly payments becomes overwhelming. To reduce the burden, you take out another loan in the form of debt consolidation. While bundling together one's high-interest debts and refinancing them at a lower interest rate sounds like a smart idea, the reality is that most people end up even deeper in debt within just a few years. As soon as their monthly payments decline, their rate of spending increases.

A few rounds of debt consolidation later, many people find that so much of their income is going to pay outstanding debts that they can no longer stay current on other expenses. Eventually, this results in a damaged credit score, which leads to an inability to borrow at low interest rates. High interest rate loans and credit card payments further restrict cash flow, and can lead to bankruptcy. Although bankruptcy may provide a means to reset one's finances and start over, oftentimes it merely acts in a manner similar to debt consolidation and marks the beginning of another debt spiral.
Break the Cycle

The first step in the process of escaping the debt spiral is to stop borrowing money. Credit cards are often the lead culprit in the creation of consumer debt, so put the plastic away. Pay in cash, write a check or use a no-fee debit card to make your purchases. This way, you will see how much you are spending and when the money runs out, you won't be able to spend more.

Next, you should take a close look at your income and expenses. While many people chafe at the idea of living on a budget, the reality is everyone does (unless they've got an unlimited income). If you just can't handle the idea of tracking every penny that you spend, it's still a good idea to periodically review your income and compare it to your expenditures. At the very least, you will figure out whether you are shelling out more than you are bringing in.
The Road to Recovery

Once you've made the commitment to fix your financial problems and taken the time to evaluate your income and your outflows, it's time to take a look at your lifestyle. Making adjustments in your lifestyle will give you the opportunity to implement a plan to put yourself on a firm financial footing.

If your financial evaluation revealed that you do indeed spend more than you earn, you'll need to figure out a way to change that equation. While getting your cash inflows and outflows to equilibrium is an absolute necessity, it is not enough to solve your problems.

You need to reduce your expenses to the point where you are generating a surplus. Alternatively, you can increase your income. Generally, most people are more willing and able to cut expenses than to increase their incomes, so we'll focus on that path. Just keep in mind that changing jobs or taking a second job may be viable options that can help speed up the timetable for reaching your goals.

Reducing your expenses by a meaningful amount may require some serious lifestyle changes. Housing and transportation are two of the biggest costs for most people. Moving to a less expensive residence is often a way to make a meaningful and substantial reduction in your expenses. It may cost a few dollars to make the change, but the long-term benefits often outweigh the short-term expenses.

Similarly, trading in your car for a less expensive vehicle can result in hundreds of dollars per month in savings when your car payment, insurance payment and monthly gasoline bills are all reduced.

Cutting back on discretionary spending is the next step in the process. This step is often the most challenging for people who don't like to keep track of where their money goes each and every day. Even if you are not willing to make a conscious decision to closely evaluate your spending habits and cut out certain expenses, the simple act of paying with cash rather than by credit can help you become more aware of how much you spend and how much you have left in your pocket.
The Next Steps

After you've figured out a method of reducing your expenses or increasing your income to the point where you have a surplus each month, it's time to put that surplus to work. Start by giving some of that money to yourself. Instead of spending that surplus cash, stash some of it away for a "rainy day." It's the 'pay yourself first' concept. Rather than using the money to buy more stuff, setting that money aside creates an emergency fund that you can tap into when you need money in a hurry. If a rainy day arrives and you have to spend the money, replace it as soon as possible. Ideally, you'll want to have enough money stashed away to cover at least several months' worth of expenses. If that seems like a big number, don't be discouraged. Having an extra $50 set aside is a great place to start.

In addition to putting some money aside for yourself, you'll also want to start paying down your debts. Here, are two paths that you can consider. The first, and most mathematically logical, is to pay off your highest interest debts first. This will result in the most financial savings, but if you have large balances on your accounts it may take a long time before you feel like you have made any progress.

If that approach is simply too disheartening for you, consider paying off your lowest balance loans first. While less financially effective, this plan can be more emotionally rewarding. Once you've paid off one debt, you will be more likely to pay off the next one and the one after that. Although this approach isn't the most logical, it provides faster progress which can encourage your new habit.
The Bottom Line

To break the debt spiral, patience is a virtue. Anything that motivates you to take action and stick to your plan is worthwhile. Remember, it took years (perhaps decades) to build up those outstanding balances. Recovery will be a similarly slow process.
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