Overview: Why People Go into Debt

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Overview: Why People Go into Debt

What It Means

The term debt refers to something (whether it is money, a piece of property, or a service) that an individual owes to another individual or an entity. In most cases people owe a debt because they have borrowed something from someone else. Debts arise frequently in everyday life, in a variety of contexts. In cases involving people who know each other, debts may take the form of informal understandings and are primarily a way for people to repay favors. For example, a person might owe (or feel that he owes) his neighbor a ride to the airport because that neighbor took care of his dog while he was on vacation. In another instance a friend might owe another friend lunch because that friend helped her move into a new apartment. In these cases the debt is rarely called a debt and is generally considered nonbinding; that is to say there is no real obligation, outside of a sense of personal responsibility, to repay the person who performed the favor.

In modern economic terms debt refers almost exclusively to financial debt (in other words money). When people borrow money they do so with the understanding that they will pay the money back at a later date; the money that a person owes is referred to as debt. In some cases a person borrows a specific amount of money, which they receive all at once, in what is called a lump sum. This type of borrowed money is typically referred to as a loan. In other cases a person applies for credit. Typically credit refers to an amount of money that is made available for a person to borrow, usually with a specified maximum amount that can be borrowed, known as a credit limit. Credit is available in various forms; the most common type of credit among American consumers is the credit card. A credit card is a plastic card that a person (in this case known as a cardholder) can use to make purchases, receive cash (known as a cash advance), or pay off other debts, up to the credit limit specified in the card agreement. The more a person spends (or charges) with a credit card, the more debt he or she accrues.

In most cases people borrow money or receive credit from established financial institutions, such as a bank, a lending company, or a credit card company. When a person borrows money from a financial institution, that money is subject to an interest charge. In basic terms interest represents the fee a financial institution charges a person when he or she borrows money. Interest is reflected as a percentage of the amount of money borrowed and is generally calculated on an annual basis. When people borrow money the total amount of their debt is not limited to the amount of money borrowed; their debt also includes the interest that accumulates on the borrowed money over time. The longer a person remains in debt, the greater the amount of interest he or she will ultimately pay. People who owe debts are commonly known as debtors, while the people to whom they owe the money are called creditors.

When Did It Begin

Debt has existed since the earliest human civilizations. Ancient societies often imposed severe penalties on people who failed to repay their debts in a timely manner. In Babylonia (a kingdom that existed between roughly 2000 and 540 bc , in a region covering what is now Iraq) debtors who were unable to pay their creditors were frequently imprisoned. The Code of Hammurabi, a legal code devised in the eighteenth century bc by the Babylonian king Hammurabi, allowed a debtor to offer his creditor a piece of property, in the event he had no money to repay his debt. In certain cases a debtor in Babylonia might be forced to sell one of his family members into temporary slavery (for a period not exceeding three years) to satisfy his debt.

Ancient Hebrew law (the law of the early Jewish race, written around 1000 bc ) contained numerous rules and stipulations relating to unpaid debts. In some cases a man who borrowed money gave his creditor one of his possessions to hold as a guarantee that he would repay the debt (in modern terminology this possession is known as collateral, while the type of debt is often referred to as a secured debt, in that the piece of property acts as security that the debt will be paid). In order to protect debtors who were poor, Hebrew law required a creditor to return the piece of property to the debtor before nightfall; references to this rule appear in the Old Testament of the Bible, in the books of Exodus (22:26–27) and Deuteronomy (24:11–13). As in ancient Babylonia, Hebrew law also allowed slavery as a means of resolving unpaid debt, although in this case the debtor himself was the one who was enslaved. Similar laws permitting the enslavement of debtors also existed in ancient Greek and Roman civilizations.

Throughout medieval Europe (a period of European history also known as the Middle Ages that roughly spanned the fifth through the fifteenth century ad ) and well into the nineteenth century, debtors were frequently thrown into debtors prisons for failing to repay debts. Debtors prisons were notorious for their unhealthy, crowded conditions, and many debtors died before being released. Debtors prisons were also established in the United States during the colonial period. By the eighteenth century people began to speak out against the inhumane treatment suffered by inmates of debtors prison. English author Samuel Johnson (1709–84) was an outspoken critic of the institution; one of his close friends, the poet Richard Savage (1697–1743), died in debtors prison. Johnson declared that “the confinement…of any man in the sloth and darkness of a prison, is a loss to the nation, and no gain to the creditor.” Debtors prisons were finally outlawed in the United States in 1833; England followed suit in 1869, with passage of the Debtors Act.

In early nineteenth-century America people often fled to the frontier to elude creditors; indeed, if someone was said to have “gone to Texas,” it was understood that he had become insolvent (in other words he was unable to pay his debts; this is also known as being bankrupt).

More Detailed Information

People go into debt for a variety of reasons. In many cases people take on debt because they want to make a major purchase (such as buying a car or a home) that they cannot afford to pay for in cash. In most instances these purchases can be described as necessary; people need to live somewhere, and most people need some form of reliable transportation to get to work. If people tried to save up the money necessary to buy a house with cash, they would likely have to wait several years, if not decades, before they had enough money to purchase the house. Furthermore they would be spending a good deal of their monthly income on rent, which would further delay their home purchase. By going into debt to purchase a home, on the other hand, a person could inhabit the home right away. His or her monthly loan payment (also known as a mortgage) would be roughly comparable to the amount of money he or she would spend on rent each month. Technically the person would not own the home outright; the lending institution would own it until the person had paid for the house in its entirety. Still the person would be paying toward full ownership of the house, while also building equity (the share a person has of a house’s monetary value) in the meantime.

In this sense taking out a loan in order to purchase a home is often referred to as good debt, in that it offers a substantial reward (ownership of the house) after the debt is paid off. Several other forms of debt can be considered good debt. For example, taking out a loan to pay for a college education (commonly known as a student loan) is generally regarded to be a form of good debt, because the reward of receiving a college degree typically translates into a higher income in the future. By having put himself or herself in a position to obtain a high-paying job after graduation, a college graduate not only will earn the money to pay off student loans in a relatively short period of time but also will have a greater range of financial choices in general, in large part as a result of his or her education. Buying a car could also be considered good debt, in that a person paying a monthly car loan is paying toward full ownership of the car (as a person paying a monthly home mortgage does toward a house). Granted a car does not build equity the way a house does; cars tend to lose value, or depreciate, over time, while in almost all cases houses gain value, or appreciate. Still, if a person takes good care of a car, that car will prove to have been a good investment after it has been fully paid for.

Some debts, on the other hand, do not qualify as necessary and contain little to no future value for the debtor. This debt could be categorized as bad debt. In general credit card debt (also known as consumer debt) qualifies as bad debt. Many people use credit cards to make purchases that have no lasting value, such as dining out at a restaurant, purchasing groceries, or buying clothes. All people need to eat and wear clothing, so these purchases are in one sense necessary. But these are not the sorts of purchases that justify going into debt. People who work a job earn a certain amount of money every month for living expenses, which includes food and clothing. If a person’s income allows for $400 a month to be spent on food and clothing, then it is reasonable for that person to limit that spending to $400. Many people fall into debt, however, when they use a credit card to buy more consumer goods than they can afford to pay for each month. If a person routinely spends $500 a month on food and clothing and can only reasonably afford $400, he or she will have accrued $1,200 in debt in a year’s time. When one factors in interest charges, that debt will expand substantially. If this pattern were to continue for several years, that person would develop a significant debt problem.

Some forms of debt are unavoidable. For example, if a person becomes seriously injured in a car crash and does not have health insurance, he or she might be forced to take on debt to receive proper medical care. Often this debt will be very expensive (health-care costs have risen dramatically in the United States since the 1990s), but to most people it will prove far preferable to living with permanent health problems.

Recent Trends

In the United States the total amount of personal debt rose considerably between the early 1990s and the first decade of the twenty-first century. In 1994 consumer debt in the United States amounted to roughly a trillion dollars; by 2004 this total had risen to $2.14 trillion. Mortgage debts also rose substantially over these years, from roughly $3.2 trillion in 1994 to $7.6 trillion in 2004.

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Overview: Why People Go into Debt

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