We often hear about the income gap. But what about the debt gap? Some people have no debt and some people have debt up to their eyeballs. It has nothing to do with numeracy (how good one is with numbers).
After preparing many financial plans, I can tell you that this phenomenon cuts across net worth. It doesn't matter much if someone earns $40,000 or $400,000, some people have a tendency to use too much credit.
Stephan Meier and Charles Sprenger's study, Present-Biased Preferences and Credit Card Borrowing, finds that people who are present-biased (desire immediate consumption) have significantly higher amounts of credit-card debt. The study controls for income and other social factors, not to mention the well-documented evidence that people tend to under-report their total debt levels. Their research cited an average of $3,027 in non-mortgage debt a person, but when you look only at people who carry balances on their credit cards this number almost doubles to $5,799.
Someone who wants the latest iPhone the day it’s released is obviously more likely to borrow money to finance the purchase. And they may not place an equal importance on future ramifications.
With the holidays stepping into high gear, many people break their spending rules with the simple justification, “It's Christmas!” or whatever holiday they celebrate. This is a similar line of thinking as “You only live once!” Those four words are usually uttered moments before doing something you know is stupid.
Suspending the requirement to balance your cheque book occurs for other occasions as well. A promotion at work, a new job, getting married. The list is endless, with some offences clearly worse than others. But the point is that these once-in-a-while splurges are justified with emotions, not math.
This is exactly the present bias described in the study. If you happen to be one of those people who lives and spends in the moment, you have to learn how to handle your bias. Think back over the course of the year and figure out how much “extra” money you spent on indulgent expenses. Add it up and divide by 12. This is your new monthly savings amount. Set it up with your bank to withdraw it automatically every month.
This new (somewhat draconian) plan will mean that for the next year not only will you have a cash-flow drain from the automatic savings, you will still have to pay off the debts from last year (and who knows how many previous years carried forward). But welcome to the real world where past choices catch up with you.
You can choose to fix it now, and that might mean delayed gratification for a year or two, or you can roll the dice and see what happens when interest rates start to rise. Earning interest is better than being charged interest, and in the long run it means you can actually buy more.
Because it's true. You only live once. So don't screw it up.
Some things to consider:
Canadian debt levels have swollen faster than our waistlines will over the holidays. Come January, consider building a debt plan to go with your new workout routine.
Number of credit cards in circulation in 1977: 8.2 million Number of credit cards in circulation in 2010: 70.3 million Total sales and cash advances on credit cards in 1977: $4.04-billion Total sales and cash advances on credit cards in 2010: $308.98-billion Source: Canadian Bankers Association
From a survey of 1,000 Canadian homeowners with household income over $50,000:
56% do not, or do not intend to, have a debt-repayment plan with an ultimate pay-off date 65% did not shop for better interest rates on their mortgage through different providers 55% do not plan to work with an adviser to get advice on debt management 43% do not plan to consolidate credit into a single low-interest rate Source: Manulife Bank of Canada