Paths That Lead to Debt and How to Avoid Them

Many might wrongly assume the leading cause of falling into a debt spiral is simple financial irresponsibility, however, more often than not, this is simply not the case.

Loss in Income & The Wealth Effect

The more money you earn the more money you tend to spend. This an effect of what the market calls lifestyle inflation. You can have a fantastic income and still end up in debt if your monthly expenditures outweigh your income. Psychologically speaking, the wealth effect is very real. Regardless of which assets see an appreciation in value (this can be appreciation in the value of your home, appreciation in your investment portfolio during a bull market, or a simple increase in income), human nature tends to show that consumers do in fact spend more when they feel wealthier.

So, when does spending more because you earn more go wrong? This occurs when an exogenous variable impacts your financial situation and ability to earn. Many consumers saw this occur during the beginning of the pandemic, when many employers slashed income by 10%, 20%, 30%, etc. due to economic uncertainty. If you as a consumer saw a loss in income and were slow to react to it and still tried to maintain the same lifestyle you had before the loss in income, the odds of getting into burdensome debt increase exponentially.

So, how can you avoid this happening to you? When your income increases, counter the trend! Save more of your money, invest it, establish a rainy day and emergency savings. The best way to do this is by better understanding human nature. Account for the fact that things may not always be as “rosy” as they are now. To avoid spending more, allocate more of your income into distributions for savings (if possible, it’s best if they are automatically deducted from your income check). Tactical budgeting will also help in this scenario. If your income has decreased by 20% you need to be fully aware of what you are spending on and understand that you cannot maintain the same lifestyle you were previously.

Medical Issues

For many an unexpected medical expense can be a double whammy and lead to serious financial hardship. First, you have to deal with the outsized cost of paying for your medical treatment. Second, it’s very likely the medical issue will impact your ability to work and earn income in the near term. So, in this scenario, your cost of living and staying healthy are rising while your income is also diminishing. Hence, the double whammy. This is a very unfortunate way to accrue debt.

How to avoid: It’s tough to be completely prepared for something like this, unless you are extremely well-off, but there are simple things you can do to help stave off unexpected medical expenses. The best way to prepare for any medical curveballs life throws your way is with sufficient medical insurance and a nest egg. The larger your nest egg the more prepared you will be. Perform regular checks in and always keep tabs on any medical vulnerabilities you may have. Health is much more important than money, money cannot buy health.

Divorce

Divorce is terrible in every way. It can substantially impact your state of mind and emotions but more than this it’s a substantial change that can destroy your finances. When it comes to the financial aspect of divorce, it is a triple whammy (typically for both sides). Divorcees have to pay a lot in legal fees and deal with the emotional toll of splitting all their belongings, etc. Moreover, they both have to deal with going from a joint income to a singular one and many have a lot of trouble transitioning financially after the divorce proceedings. Many couples get extremely acclimated to the division of responsibility and roles within their relationship so when they come out from the other side of the divorce they basically have to “start over” again. Throw children in the mix and this can definitely be a “scary nightmare”.

How to avoid: *If only there was a clear answer here the world would be so much better for it. However, financially there are definitely steps you can take. A lot of couples’ have a clear division of finances and responsibilities within their marriage. They pay bills separately and have a clear sense of what responsibilities they have. Ideally, after a divorce, if both parties remain civil, you can retain some type of friendly relationship and mutual understanding. In this case, things may not be so bad. Otherwise, it may be worth considering a pre-nuptial agreement or setting up boundaries if things do end up going south.

Education

Lastly, this is also somewhat tangential to the topic but the cost of education in America is very high. If we want to pursue a higher education we are basically forced into debt. For many, our only options are to forego higher education completely or to rob ourselves of future earnings by taking on substantial student loans. For individuals that designate the resources towards earning a higher education and then do not succeed in completing their degree the negative is two-fold. They are stuck with student loans and do not receive the benefits of having achieved a higher education. Definitely a very unfortunate way to get into debt.

How to avoid: Make sure college is the best life decision for you! College is not for everyone, never feel pressured to achieve a higher level of education if you feel it’s not something you want to pursue. Otherwise, you should try to qualify for scholarships wherever possible! You can also consider attending a much more affordable state school and then transferring to the school of your dreams after you have attended the state school for some time. At the end of the day, your degree is the same! It doesn’t matter if you attended a state school for 2-3 years, your diploma will still show the school you graduated from.