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Credit Card Debt and the Art of Consumption Smoothing

Posted by Ben Jardine on 20 February.

The festive period has come and gone. You’ve had your presents, your dinner, your beach holiday. But then you get a letter in the mail, a credit card statement: you overspent over the holidays and as a result, you’ve been hit with a massive amount of credit card debt that you need to repay before next month.

 

This is a familiar story for many. Much like quicksand, overwhelming debt can quickly swallow you up without any hesitation. It’s easy to rack up debt but much harder to pay it off. Especially if you earn an independent (aka ‘lumpy’) income, it becomes even more difficult to know when you’ll even be able to repay those debts or make those direct debits without risking overdraft.

If you’re interested in tackling your debt right away, it’s important to actually understand what debt is, how it comes about, and the ways in which you can pay it off.

 

So What is Debt and How Can I Get Out Of It?

At its most basic, debt is a form of financial overextension. You spend your future dollars today, which always comes at a cost.

The scenario often goes something like this:

  1. You can’t afford to buy an item or service, so you use a credit card and rack up some debt.
  2. You then dig into your existing income in order to pay off that credit card debt.
  3. Now you’re worse off than when you started: you still can’t afford to buy stuff, so you continue to buy stuff that you can’t afford.
  4. The cycle of debt continues; the quicksand keeps rising while you keep sinking.

When you earn an inconsistent income, you might have to closely oversee your payments and rely on others to remember to pay you for your work. In these instances, there is no fixed ‘pay-date’ – not only might you have different amounts of pay coming in each time, but the frequency of those payments is also variable. Many people who find themselves in this situation might use short term debt as a reactive measure to help them overcome those inconsistent earnings periods.

If you work a contract here and a contract there, you might encounter a fortnight or even a month where you’ll have no other choice but to take out a loan or use your credit card to pay for essential utilities. In this instance, it can be very difficult to avoid going into that kind of debt, as these are unavoidable purchases or payments. After all, you can’t go without electricity or groceries.

To enjoy a good quality lifestyle throughout the different stages of life, to have just a little bit of financial freedom as your career develops, credit card payments can be an incredibly necessary evil – if deployed at the right time. Credit card debt, however, can be avoided.

So what if you could plan, in advance, for those moments of financial ebb and flow?

 

Creating a Plan

Of course, the easiest way to avoid accumulating debt is to spend within your limits whenever and wherever you can. For both avoiding debt and paying off debt, here are some methods you might look at putting into place today, which might help you out tomorrow:

To Avoid Debt
  • Set up an emergency fund, in which you pool money on a regular basis to help smooth over those periods of lower income, or to help you afford bigger shops like those around the festive season or the set-up costs of a new home. You also never know when you might need to get specific services done, like emergency car maintenance or house repairs. Therefore, it’s crucial to have an emergency savings fund that you can dip into as needed. Our friends at Sorted recommend having a starter safety net of $1,000.
  • Strategise your spending: only borrow for items that you absolutely need and can see yourself actually paying off in the next month.
  • Map out your finances: where are you currently spending the majority of your money? How much are you putting aside, versus spending, right now? Are there any unnecessary regular purchases that you can deprioritise?
  • Make the most of online tools. They’re free! If all of this is feeling overwhelming, there are some tools that can help you get a leg up on your debts and perhaps help you to avoid them altogether. Sorted have some handy tools that can help you out: Sorted’s budgeting tool Debt calculator
To Pay Off Existing Debt
  • Establish a strategy: after calculating the amount of debt you might be owing, set up a repayment schedule. Check to see what the minimum monthly payment is (what you need to pay in order to keep the debt at bay and not risk incurring additional debt). Always at least match that. Moreover, different types of purchases will give you a different interest rate on the subsequent debt. Knowing the interest rates of your various debts and how they may affect your ability to pay them off is crucial to saving yourself time, stress and money.
  • Don’t stretch yourself thin in an attempt to sort out all your debt at once. Just like quicksand, the harder you try and escape debt’s clutches, the faster you may sink. Try and choose which type of interest you’d like to tackle first: higher interest debts (this is called the ‘avalanche’ method) or lower interest debts (‘snowball’).
  • Establish ‘sensible spending’ habits and stick with them.
  • Change your perspective: the acute dangers of debt (and the benefits of planning in advance) become even more apparent when examined through the lens of consumption smoothing.

 

Consumption Smoothing

Consumption smoothing is the idea that through better balancing your consumption patterns and your saving trends at different stages in your life, you might achieve a greater quality of life over the course of your entire lifetime. As a young person, this distinction could be between living more cheaply today while putting money away for KiwiSaver on a regular basis. Or, later on in life, perhaps investing in non-liquid assets (such as real estate and land), while continuing to live relatively cheaply, which will increase one’s net worth in the long run.

Through the concept of consumption smoothing, it becomes more apparent why generally avoiding debt early on in life is the smartest move you can make in your career. If you can avoid it, why overextend and risk being on the hook for payments you cannot make?

But consumption smoothing comes with a pretty important caveat. It can be risky to offload financial responsibility onto your “future self” when you can take the steps earlier on in life to better prepare for that inevitable day. So for now, try and get into the habit of making smart savings decisions while you have the ability. The future is, of course, unpredictable. And your future self isn’t the most reliable. So stick with what you know today, the bills you have to pay this month. Rather than waiting for an idealised future, try to plan for that future now.

Who knows if you’ll have job security for the next few years? Or if your field goes through a great deal of innovative change and you need retraining in order to progress further? Making sure that you’re prepared for the multiple challenges, some completely unforeseen, that life might throw your way is the best way to take care of yourself for today and for tomorrow.

So start with making a plan for day-to-day spending and debt repayment, but keep an eye fixed on the future. To try and smooth out your spending and saving patterns over the course of your life (aka consumption smoothing), attempt to not overspend when you’ve got the money, and try your best to avoid debt when you’re earning a lower income than your ‘average’ lifelong income. And through the use of helpful online tools, you can start to visualize the work you might have to do in order to get a leg up on your current and future debts.

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