Sunday, August 10, 2008

Escaping the Burdens of Consumer Debt

As the economy slows and onerous debt hangs ominously over the heads of consumers and corporations, the excesses of the housing boom are a cancer on the U.S. economy that must be cured before recovery can ensue. While banks raise additional capital and reduce credit availability, consumers confront a changing landscape where it is no longer possible to repeatedly consolidate debt in response to excessive consumption. Instead, consumers must face the consequences of their consumption lifestyle and begin to amortize the debt incurred during the glory years of the housing boom. In support of this noble endeavor, some strategies for reducing consumer debt and strengthening one’s financial standing follow.

Distinguish between needs and wants. Perhaps the biggest difference between the chronically indebted and the financial secure consumer is the ability to distinguish between needs and wants. For example, everyone has basic needs such as food, shelter, and clothing, but how these needs are satisfied can greatly contribute to financial independence. Too many consumers satiate their basic needs with products that are premium priced in order to maintain an image of success or alleviate feelings of inadequacy. People burdened with excessive consumer and mortgage debt should consider shopping for clothing at Target as opposed to purchasing the designer wares of Bloomingdales. Similarly, that steak at Ruth’s Chris should be foregone in exchange for a burger at home. When burdened by substantial debt, even smaller purchases such as CDs, a night at the movies, or a Starbucks coffee should be considered unnecessary luxuries.

Many small victories win the war. Dramatic progress can be made towards reducing debt by focusing on the frequent small purchases that are made on a daily basis. By eliminating frequent purchases of luxury items such as the $5 coffee, $8 sandwich for lunch, or even a soda from the vending machine, one can save an incredibly surprising amount of money thereby slowing the accumulation of new debt and facilitating the reduction of existing debt. While it may be less desirable to drink the free coffee in the office or bring a lunch from home, the obligations incurred during previous spending binges dictate that little luxuries must be sacrificed.

Segregate funds and identify savings. In order to instill a sense of discipline, it is important to explicitly segregate funds to ensure that habits of excessive consumption are curtailed. Every day that you sacrifice the morning coffee or lunch out, take a $5 bill and place it in a special envelope or jar. In order to ensure this piggy bank is not raided in a moment of weakness, the dollars collected should be applied towards outstanding debt by making debt payments weekly in addition to the regular monthly payment. Each payment will reduce outstanding principal and expedite the retiring of existing debt.

Focus on high interest revolving debt first. The supplemental debt payments should be applied to debt with the highest interest rates first. In additional, priority should be given to debt with payments that will vary based on outstanding principal balances such as credit cards. By paying down revolving debt, the monthly debt burden will be reduced as the fixed required payments will decline as the principal balance erodes. Ideally, one would continue to make the same monthly payment even if the required payment is reduced, but the lower periodic payment provides greater flexibility in the event unexpected expenses arise.

When you incur excessive debt, you relinquish your right to future consumption in order to satisfy immediate wants. You have no right to the $1200 Marc Jacobs purse or $300 pair of jeans because you sacrificed future consumption in order to finance the widescreen TV, expensive dinner, and vacation that you purchased on credit yesterday. Frequently, the mentality that abundant future income will alleviate the debts of the past leads to crippling debt levels that become onerous in the event of unexpected illness, job loss, or other expenses. Personal responsibility and accountability are often lacking in the U.S., especially given the growing socialization of individual excesses through government bailouts, tax credits, and market interference. The current contraction in credit, however, will hopefully instill a discipline among consumers and lead to the reemergence of the virtues of saving and investing, through which financial independence can be attained.