Saturday, May 31, 2008

Our path to financial ruin has been "charted"

I always love reading Hale "Bonddad" Stewart's columns on HuffPost. His most recent is a doozy. He shows how the most recent economic expansion was created on a mountain of government and household debt. Wanna see my favorite chart? Here it is:

I'm not an economist, but if we see that in 2005, our cumulative household debt equaled more than 125% of our disposable income, one can safely state that we are not creating wealth. On the contrary, we are actually creating more and more debt to simulate wealth. You remember Stanley Johnson, don't you? No? Well, get acquainted with him again here.

I wouldn't always advocate a home refinance to consolidate debt unless one takes the next step and effects a personal paradigm shift in the way one spends and saves money. Basically, don't spend more money than you have. If you can't afford to pay off credit card debt monthly, don't buy that fancy LCD TV or those Sea-Doos.

Living within one's means is and should be taught by parents to their kids, not to mention in school. But if Americans are not living the principles of "living within one's means," then how can it be taught?

Tear up the credit cards and start saving your money. If the high price of gas and this low-confidence economy isn't getting you there, do a little math. Let's say you and your family are an average family and earn $40,000 per year after taxes. If you can live off of 90% of that net income, your housing payment, loan payments, living expenses, etc., are $36,000, leaving you with disposable income of just $4,000 per year.

Based on the above chart, your household debt -- credit cards, car loans, student loans, etc. -- is on average a little more than $5,000. This might not seem like an awful lot of money to some people, but consider for a moment that this amount of debt never goes down. Scary thing, huh? You're always going to be in debt.

Suppose you could only take 10% of your disposable income and throw it at your debt. Assuming that your consumer debt is at about 12% interest per year, compounded (naturally), after a year your $5,000 would now be $5,211. You'd actually be increasing your debt! Even if you doubled your payments to 20% of your disposable income per year, it would take you 140 months, nearly 12 years, to pay off just that $5,000 debt. Meanwhile, you would have paid nearly $4,300 in interest, about as much as you had in debt in the first place.

Just to kick it up a notch, let's say you had no debt, but actually $5,000 in savings. You could contribute that same 20% of your disposable income over 140 months at a modest 5% interest rate. With compounding, your principal would then be over $21,500. Spending the $9,300 that you would have spent in retiring just $5,000 in debt would nearly double in value in that time frame.

So you see, getting out of debt isn't easy if you're not living within your means. And Bush administration officials and other Republicans who tout how strong the economy is never mention the fundamental problem here: at some point we have to pay back this debt. Everyone seems to be missing this most basic fact of life. How can an economy be strong when we have this much debt?

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