How Debt Affects Your Spending

A new study from Stanford University shows that households with higher levels of debt are much more sensitive to changes in income levels than those with lower debt loads.

This seems obvious in hindsight, but households with a large buildup in debt were much more ill-prepared for declines in asset prices during the financial crisis than those who saved and avoided borrowing.

As housing and stock prices fell during the crisis, those with higher levels of debt were forced to cut back their consumption a great deal.

It’s also true that those with more debt aren’t generally allowed access to newer forms of credit because they are so overleveraged. Those that needed a backstop from new loans or other forms of credit during the downturn were unable to access them.

So the double whammy of asset/investment price declines with possible income level volatility led to a third issue of having to drastically cut back on spending levels.

Since the debt was so high and consumer balance sheets were in such disarray leading up to the financial crisis of 2007-09, consumption dropped by more than 25% during the period than if consumer debt had been at more reasonable levels seen in the 1980s.

Basically, because there was so much debt in the system, the Great Recession lasted much longer than the average business cycle would normally produce.

This is also one of the reasons that the recovery has been so muddled. Instead of saving and investing since 2009, households have been forced to use their funds to pay back debt loads that were far too large for them to handle.

It wasn’t covered in the study, but those who liberally use debt to fund their lifestyle also run the risk of piling on even more debt when their income does rise.

Instead of being happy with their current standard of living, many people continue to leverage their future in the form of increased current expenses to keep up the appearance of a wealthy lifestyle.

The financial crisis showed people that this strategy works right up until it doesn’t. It’s a personal Bernie Madoff strategy that is unsustainable.

The economy actually needs debt to function. Otherwise there would never be investment, growth or future progress.

Yet your household doesn’t need to take on unwarranted debt (credit cards, store cards, large car loans, etc.) to function properly.

Saving helps you get ahead in life by thinking about your future self. Debt holds you back and causes you to be painfully reminded of your past self.

Debt and the consumption response to household income shocks (SSRN)

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  1. Martin commented on Jan 28

    I can tell you this first hand. As I have the debt, I had hard time struggling to get along. It works also the other way, the debt will prevent you from saving and thus make you totally unprepared for crises.

    • Ben commented on Jan 29

      Yes, it’s a vicious cycle. Not all debt it bad, but loading up on credit cards and huge car loans makes downturns much worse. If anything, credit cards should be used as an emergency stopgap after your emergency savings fund has been drained.