Debt allows people to buy things that they otherwise would not be able to afford, improving their standard of living.
It also allows people to break up payments over a period of time reducing their financial burden. As well as benefiting individuals or families, household debt can provide stability to the whole economy by smoothing out spending during periods of temporary falls in income (Röhn et al, 2015) In countries where households and businesses have high levels of debt are seen as a sign of financial development. In advanced economies the level of private debt is much higher than in developing economies.The “life-cycle” hypothesis developed by Franco Modigliani in 1957 states that individuals seek to smooth consumption over the course of their lifetime – borrowing in times of low-income and saving during periods of high income (Pettinger, 2017a).
It is also believed that consumption depends on the expected lifetime income of an individual (Browning and Crossley, 2001). In simple terms, people generally borrow with the belief that in the future they will be earning more so they will be financially able to pay back their loan. There are two main types of debt financing – secured and unsecured.
A secured loan is when an asset is tied to a loan. This means that if a person defaults on the loan the creditor or bank will take possession of the asset. The most common example of a secured loan would be mortgages – in the UK mortgages accounted for 85% of the UK’s £1.46 trillion of personal debt. Unsecured debt on the other hand is not secured against an asset.
Examples of this include credit cards and student loans. One of the key reasons people are willing to take on debt is due to ‘economic confidence’. In cases where people are optimistic about the future people tend to take on more debt, in comparison when people are less confident people tend to shy away from taking on debt (Callaghan, Fribbance ; Higginson, 2012, pp.135-6).
Interest rates also play a part in the demand of debt products; low interest rates make it cheaper to borrow money so essentially it is cheaper to buy other goods too. As a result, demand for goods and debt products tend to rise as interest rates falls. On the other hand, the higher the interest rate the less people are willing to buy goods and debt products as borrowing is costlier. “In general, low interest rates encourage investment because they make saving less rewarding, while high interest rates tend to discourage investment.” (Hamel, 2018)Another factor to consider is inflation; if wages rise faster than inflation households will be able afford more goods and services.
However, if the opposite is true and inflation rises faster than wages, many households may find it difficult to sustain their lifestyle or living standards. As a result, they may turn to credit as a short-term solution.However, it is important to note that households with high levels of debt may face problems if their circumstances changes. For example, if the main earner suddenly loses their job it will be difficult to keep repaying the debt and may put more financial strain on the household. These households will be forced to limit their financial spending, thereby affecting their standard of living. Moreover, if the economy is going through a recession this will have a knock-on effect on the population.
During a recession people generally reduce their spending and begin to save due to uncertainty, thus the demand for consumer products decreases. Businesses then begin to reduce costs – generally labour; meaning that they either let workers go or reduce their pay. This then means that people have less disposable income, making it harder to repay their debt.