This is a rewrite of a previous article, “Will You Raise My Credit Limit Please?”
First, A backdrop of some basic principles of personal finance:
We all live with certain financial realities in our individual or household economies or “budgets”. We earn money to pay for our necessities and depending on the differential between our income and living expenses, we have either a surplus or deficit. If we have a budget surplus we may spend some or all the balance on recreation, entertainment, travel –some extras we could categorize as luxuries. Others may tuck the surplus away into rainy day/savings accounts or investments or they may spend their surplus (“blow it”), which means they no longer have a surplus. We all want a surplus of money of course. When we have a surplus or break even, we call this a balanced budget.
On the other hand, the total earned income of some individuals or households is less than the cost of the basic necessities. They just are unable to make ends meet. People in this circumstance are running a budget deficit. Therefore, they may choose to borrow money in the form of a loan and thereby incur a debt. For large purchases, they may not have the cash to buy a home or a car so they secure a loan to defer the cost and spread it out over a fixed period time, usually with fixed, equal, monthly payments. This is done by people with a surplus also. This means that debt can be a good thing despite the fact that it usually comes with a fee called interest, typically compounded monthly. Compounded interest means we pay interest upon the principal (original loan amount) as well as paying interest on the accumulating interest every month (which is why it is called “compounding” interest). Mortgage loans to purchase a home we can afford (with monthly payments) are a necessity due to the high cost of houses, and for most people the same is usually true with a car. By deferring some of the cost, we incur this debt with the promise we will make ‘annuity payments’ each month until the balance (including the principal and interest) are paid off. Until we pay this debt off, the lender holds some form of a “note” or contract.
This is where it gets juicy. Still, some people run a deficit even if they defer the costs like homes and cars because they still just don’t have enough income to meet these obligations. One very risky or flawed option is to borrow money for simple day-to-day costs. The desperate borrower might use something they own of value, or the equity in their home or a car as collateral (assuming they have equity) to secure a cash loan, again with an interest fee. The danger is that if you fail to pay them back, they take your collateral (e.g. your house or car). A common form of borrowing almost all of us use is to have an open line of credit with a bank via a credit card. It comes with a “credit limit” or debt ceiling. Most large retail companies also offer these revolving credit cards to customers to “buy now, pay later” for use in their stores. Either way, credit cards issuers often lure you in with “zero interest” IF you pay it off at the end of the monthly payment cycle, but they know a certain percentage will not do it despite our good intentions. We can use this room under the credit limit or debt ceiling on necessities or luxuries but there is a cap and a big penalty if the card holder exceeds it. In fact, the bank or credit lender will freeze the credit card account once it hits the credit limit (debt ceiling) and may charge a penalty and increase the interest rate. These types of borrowing on credit can be a very slippery slope indeed, because people who are running a deficit will use these credit accounts in desperation, even though they wont have the means to pay it off and thus lose their collateral or be sued in collections. These people are also forced to pay higher rates of interest as a penalty for exceeding limits or paying late. Stay with me, folks, this is key! People who pay late, exceed their credit limit/debt ceiling, run with deficits or have excessive debt (high debt ratios), will pay more interest, as high as 24.99%. It all can add up and eventually it will collapse on itself because it just isn’t sustainable. The interest compounding combined with the borrower’s limited, or low-income may force them to make “minimum payments”, often late, with penalties so the amount paid in fees will sometimes exceed the principle amount of the loan. That means the balance of the card is going up despite minimum monthly payments because the monthly interest fee and penalties may be larger than the minimum payment. Such a person will pay thousands of dollars for a thousand dollar loan or credit charge. Therefore they will never be able to pay it off or it will take most of a lifetime or longer. This amounts to financial bondage. What then?
“Ashes, ashes, we all fall down!”
Use of that sort of debt is a vicious cycle that often leads to financial collapse or credit “default”. People in this situation often use a provision in the law we all know as bankruptcy. The most serious form of personal bankruptcy (Chapter 7), allows them to legally be freed from any obligation for the debts and may even be able to keep some non-luxury items (necessities) if they are not extravagant. The cost of these defaults are passed on to other consumers in the form of higher prices for products and services because NOTHING IS FREE, because someone somewhere has to exert labor or pay money to produce goods and services. This means that consumers who effectively manage their finances with a balanced budget (surplus or break even), are absorbing the cost of those who default. In fairness, not all default is due to irresponsibility or mismanagement.
I will reiterate that debt can be a good thing in moderation and when the interest rates are low. Some financing is occasionally available without a fee, but this is not the norm. It is great only if you use conservative, fiscal discipline. because if you pay late, they can now charge interest retroactively. That means they back charge interest as if you had been charged interest all along! Ouch! Government subsidized student loans for college are not interest free but they offer very low-interest rates that do not start compounding interest until after the borrower has left college for a period of six months. This is a good deal because it defers the accrual of any interest until after the student has left college, hopefully with a degree and opportunity for employment to repay the loan.
That, my friends is personal finance at a fundamental level. Let’s review a list of the key terms:
- Balanced Budget
- Budget Surplus
- Budget Deficit
- Debt & Compounded Interest & Retroactive Interest
- Credit limit/Debt Ceiling
- Default & Bankruptcy
Here is the point:
What’s good for the goose –Is it good for the gander?
You and I (a goose), are bound by these economic principles of personal finance. Let us apply this to the U.S. Government (the gander). We all should recall the war in Washington D.C. over raising the “debt ceiling” (that term should sound familiar). During that war of words and tumult of opinions, the terms “debt ceiling” and “budget deficit” were thrown around and seemed to be used interchangeably. Since I have laid the groundwork for these terms above, we know debt and deficit are different. Debt is a tool used to leverage or defer expenses to keep budgets in balance so they don’t run a deficit. If a deficit runs too long it is likely to lead to default or bankruptcy. Debt can be good, but deficits are never desirable. We were told effectively, that the sky would fall if we didn’t raise the debt ceiling, and that is only partially true.
Our federal government is responsible to approve an annual budget and authorize expenses. The process of pre-determining expenses and allocating money is referred to as “appropriations”. For ourselves we call it a budget, decision or spending plan. The federal government uses the personal income tax code/law as the primary means to raise money (income) to fund expenses. The federal government is also responsible to determine the expenses necessary (remember “necessities”?), to fund operations and programs such as national defense (e.g. military, NSA, homeland defense), regulatory enforcement, the IRS, salaries of federal employees, infrastructure support, social programs (e.g Social Security, Food Stamps, Planned Parenthood, Affordable Healthcare/Obama-care etc.). Note: This is not a discussion about which programs are appropriate and at what levels they should be funded. Both revenue collection (income), and appropriations (spending or expense allocation) are part of the federal budget. It may surprise some of us that the federal government is not mandated by law to have a balanced budget. This means they can repeatedly run a federal budget deficit without any legal consequences to themselves. Sadly, this is what our federal government continually has done and it has consequences, but they are consequences for you and me (probably more for you younger people). Politicians and bureaucrats warn us that we need to fund all these important programs and warn us of dire consequences if we don’t fund or expand them. I have not touched on monetary policy as a tool for influencing economic growth but it is a key ingredient so click here to learn more about monetary policy.
Tightening the belt with “cuts” to balance the budget:
One thing we ought to be aware of is a political term (or trick), that politicians use to throw us off. They will often say they have “cut” spending. In reality they are usually not really cutting spending, especially if the cut is less that the rate of inflation. So then, funding/spending increased but they reduced the rate at which it increased. They call that a cut. Try not to laugh. But we have been getting duped for decades by that trickery. Let me illustrate with an example. Let’s say a government program’s cost increases 10% annually. Let’s say it was appropriated $100 million dollars in year one. The next year it increased 10% or $10 million, to a budget of $110 million, then another 10% increase to $121 million the next year. In year 4 they only increase the budget by 9% (UP to about $131.8 million) instead of 10% ($133.1 million), so they call it a budget cut. The Presidents or Congress may call this a cut but we certainly don’t, because spending still went up from $121 million to $131.8 million. This is especially so if our national income is not increasing at, or above the rate spending is increasing (such as our hypothetical 10% or even 9% example). We know that an actual cut would be (for example), going from $121 million down to $119 million.
Or Raise the debt ceiling debate instead:
You may recall when our “government shutdown” occurred, and the political parties were posturing and were pointing the finger of blame at one another. In reality both parties were at fault. Let me go out on a limb and say, that to a large extent, WE are at fault because we continue to let them have our national credit card and run deficits and sink us further into debt and raise the credit limit (debt ceiling). Imagine if you left your credit card with an older child while you are gone on a trip, so they can take care of some basic necessities but when you return, you realize the “blew the budget” or exceeded the credit limit and ran a deficit. Next trip, will you do the same or will you employ some restraints? You may have seen the national debt clock. It is a real-time, live representation of our national debt and deficit levels. After you look at it, make a note of the dollar amount, leave it open and come back to it at the end of the article. Click on the Debt Clock image (above) or click here.
Try to make sense of these numbers. It is a bit confusing because we just don’t relate to money at such large quantities. What if we shrunk the actual federal, debt, deficit, cuts, expenses, income etc. down to the proportional size of the average (median) household budget? That I can relate to because the numbers mean something to me in that context so I can wrap my brain around it. That is exactly what the very entertaining and funny, satirical video short, “Debt Limit – A Guide To American Federal Debt Made Easy” (below) does. Many politicians were adamant that we raise the Debt Ceiling during the “crisis”. That would be equivalent to the man in this video who is asking to have his credit limit extended or raised so he can borrow more money. Remember his crisis? Amazing, isn’t it!? How did you like the little kid at the end signing the note? Was that a representation of you, the younger generations?
Conclusion – Buckle up boys & girls:
No doubt we are in a pickle. We baby boomers have mortgaged our future and our children’s future. We have funded pie in the sky programs that make us feel good or give us “free stuff”. But is it free? Our children will not think so when they get the bill (remember the child in the video you just watched). But heck, we baby boomers may be dead and gone by then so spend on! Well, you younger generations can decide if we can we afford to buy everyone healthcare, homes, food etc.? Can we continue to fund wars that don’t have clear objectives that are satisfied? Do you think our ongoing deficits are sustainable? Is there bankruptcy court for our government? If the U.S. does financially implode (default on its debt), what then? There is always a cost! NOTHING is ever free. Unlike you and me, who have limits and are forced by lenders to meet our obligations, the federal government is not being held accountable. Politicians who want to be reelected don’t want to anger us voters so they kill us with the poison we ask for –more “free” stuff. The cost may be hidden or “deferred”, but it is NEVER free. Before you vote for representatives in government, think hard. You now have some great questions to ask them so you and I can choose someone who will tell us that nothing is free and the note will actually come due. Or we can let you generation Y or X and Millennials deal with it, or your kids if our fiscal tightrope will last that long. You younger people decide soon, because you will own it. I may be dead and gone when it comes to a head. We are at a precipice.
The video short, “U.S. Debt Crisis Explained“ puts it in a nutshell and the destination of our current path is crystal clear. At the time this video was created (about two or three years ago), the U.S. National Debt was about $14 Trillion. It is now over $18 Trillion dollars as indicated the U.S. National Debt Clock.
One more video to get you thinking.
To learn more about the Federal Reserve (or The Fed), watch this 14 minute video.