Debt and overindebtedness
We usually don’t think twice when we borrow a few euros from a friend to buy a coffee or a snack. Even children do that from time to time. Still, as soon as you borrow money, you are in debt. And if you cannot pay back your debt, it becomes a problem.
Buying a home, a car or a television – there are many reasons why most of us take on debt at some points in our lives. Sometimes debt makes sense from an economic perspective; in other cases, debt may cause problems. In any case, sooner or later, all of us will likely have to deal with debt in different life situations. For this reason, there are a few things we should know about indebtedness. For more information, read on.
Debt and indebtedness
When you borrow money (or things) from other people or from institutions, you are in debt, regardless of the amount you owe or to whom you owe it. Indebtedness does not necessarily have to be a bad thing. Neither does debt always cause problems. Taking on debt is an economic decision that means that you sacrifice future money for the sake of having it at your disposal today. In other words, you do not wait and save until you have the money you need, but you use other persons’ or institutions’ money to make a purchase. This implies that in order to be able to pay back your debt, you will have to forego future consumption. If your regular income or your assets suffice to pay back your debt, the situation is not problematic.
Debt problems and overindebtedness
Debt will become a problem if it cannot be repaid in time (that is, the borrower does not have enough liquid funds to meet their payment obligations). Overindebtedness is a situation in which a borrower is unable to meet their payment obligations in time, either from their regular income or from the sale of assets. People may find themselves in such a situation when they suddenly earn less or nothing at all and risks such as sickness, the need to care for family members or unexpected repair costs occur unexpectedly. Sometimes bad budget planning is the cause of overindebtedness. So if a person in debt gets into financial difficulties, indebtedness may become a serious problem.
The path from debt to overindebtedness is often very similar. First, a payment obligation, such as an outstanding invoice or an installment on a loan is not paid in time. Next, the creditor sends a reminder and additional fees become payable (such as reminder fees or default interest). Payment of these fees and charges may also be enforced through legal action, which means that the debtor may have to pay court costs. Eventually, the debtor is faced with a situation that is very difficult to get out of. Costs are rising beyond a level that would still be affordable.
There are many reasons for overindebtedness, but, essentially, there are three key triggers:
Unplanned handling of money
Spontaneous purchases often play a role here, as it is easy to lose track of what has already been bought and how much it cost.
Unforeseen events
Typical examples of such events are sudden job loss, failure of a business, breakdown of a relationship or sickness.
Overestimating one’s financial resources
Especially when it comes to making larger purchases, there is a risk of overestimating your own financial resources and take on more debt than you can afford to pay back.
Causes of indebtedness
Indebtedness can occur in different life situations. The reason why we incur debt is that there may be times when we want to, or need to, spend more money than we actually have at this point. We therefore borrow money from other people or institutions in order to be able to make the payments.
We usually take on debt either for investment (for example the purchase of a property) or for consumption (for example a vacation). The difference between these two options is that investments create something of lasting value (e.g. a property) whereas consumption does not.
Debt for investment
Debt is considered “for investment” when we use the funds we borrow to buy something of value or something we use for at least as long as the term of the loan. Apart from that, an investment can be of value if it generates additional income. For example, if you spend money on buying a home, renovating your home, education or setting up – or buying a stake in – a business, the money is used to create material value or generate income. In emergencies, these assets could be used to pay off outstanding debt and help to avoid a problematic financial situation in the first place.
Debt for consumption
When we borrow money for consumption, the situation is different. The value or expected useful life of the item or service financed with debt is often less than the amount and duration of the debt. If, for instance, you take out a loan to pay for a vacation, the debt may still be outstanding when the vacation is long over. Therefore, there is no material value to back the debt. More or less the same applies to items like smartphones, furniture or clothes. If such items as these need to be replaced further expenses are incurred, in addition to paying back the outstanding debt. In these cases, there is a risk of getting into financial difficulties and, consequently, into a problematic debt situation.
Hidden debt
In some situations, it is not that obvious that you are in debt. For example, when you borrow money from a friend to buy a drink on a night out, or when your parents or someone else lends you money to make a larger purchase, you are in debt. Similarly, you are in debt when your bank account is overdrawn or you opt for “buy now, pay later” (BNPL) when shopping online. Often, financing options like overdrafts or BNPL are readily available, but also potentially very expensive. The true costs may be hidden and appear only later. If you have several such payment obligations, your monthly expenses will increase; there is a risk that you lose track of your finances.
Example: Debt
A person has a monthly net income of EUR 1,700, which is enough to cover their current expenses and leaves them with EUR 100 each month to spend as they please. This person does not have any savings. Their current expenses include the monthly installment for a bank loan (EUR 150) and a streaming subscription, which costs EUR 12.99 each month.
Then this person incurs additional expenses:
The person buys a one-year gym membership for a monthly EUR 29.90. When spending EUR 320 on clothes in an online shop the other day, they opted for “paying by installments,” which means that they will have to pay monthly installments of EUR 29.12 over the next 12 months. As a result, monthly current expenses rise by almost EUR 60.
This person is currently in debt: They have to pay back their bank loan, the installments for their online purchases, and there are also the monthly payments for the gym membership.
In case of unexpected expenses (e.g. because of repairs) or if this person’s monthly income dropped, they would be in payment difficulties and may find themselves in a situation of overindebtedness.
Debt traps
It happens that people lose track of their finances, even if they have a regular income. In addition to covering their everyday expenses, they may suddenly be faced with unexpected costs, e.g. for repairs, or they may have special wishes or needs that lead to additional spending. Such spending may become a debt trap. What makes them particularly dangerous is that debt traps only become apparent when a large amount of debt has already accumulated. People often notice too late that their payment obligations are higher than their monthly income. The most common debt traps are:
Going out and ordering in
The cost of eating out and food deliveries, including a regular coffee or snack to go, can add up to large sums over time.
Tip
- Cooking at home and bringing your lunch to work can help you save money.
Subscriptions and memberships
The choice of subscriptions and memberships available today is almost endless. They usually come with fixed terms and costs. For example, (unused) memberships, internet subscriptions or streaming services initially incur low monthly costs, but these eventually add up.
Tip
- Consider not subscribing to several similar services at the same time, but rather one after the other.
Telecommunications and new media
Smartphones, tablets, TVs – the telecommunications market offers an ever-growing product range. Some people also feel social pressure to always get the latest devices. The associated costs can be a big financial burden.
Tip
- Refurbished devices usually offer all essential functionalities but come at a lower price. As regards mobile phone contracts (with or without free phones), it is worth comparing different providers.
Tip
- Have a thorough look at your risks and your insurance policies – maybe you have insurance cover that you do not really need. Comparing insurance offers online or getting professional advice may be helpful.
Overdrafts and payment in installments
Overdrawing your bank account until you receive your next salary or wage is expensive, as high interest rates and fees apply. Similarly, the use of installment financing such as “buy now, pay later” offers when buying consumer goods come with additional costs.
Tip
- Check your bank account regularly. Try not to give in to impulse buying; if you want to make a bigger purchase, it may be worth sleeping on the decision. You may decide that it’s better to wait and save instead of committing to paying in installments.
There are several ways to avoid debt traps, for example: drawing up a budget plan, building up financial reserves and critically reviewing and optimizing your spending habits from time to time.
