This may be difficult for you to believe but over the course of my 30 year career as a financial advisor, I’ve seen plenty of rich people who suffer from ruinous spending. This can often create large accumulated debts which many find unable to pay. As a result, many wealthy folks find themselves broke and with serious credit problems. Ugly.
Let’s take a look at how this happens and what you can do to avoid it.
Wealth vs Income
It’s great to be wealthy but it doesn’t mean a thing if your wealth doesn’t create enough income to sustain your lifestyle. I met a super intelligent, friendly rich man several years ago. He was worth over $15 million – but it was all tied up in real estate. The property was appreciating nicely – but not generating any income. As a result, he didn’t have enough money to live off of. He wasn’t in debt at the time but at the rate he was going, he could have easily found himself buried in it had he not taken steps to correct the issue.
When it comes to staying out of debt, your wealth isn’t that important – it’s your income that counts. And as you’ll see below, even if you have significant income, you could still end up in debt if you aren’t careful.
How High Income Leads to High Debt
There are several ways that high income could lead to high debt:
Spending more than you earn
No matter how much money you earn, it is possible for anyone to spend even more. If you earn $10,000 per month, but you spend $11,000 per month, after five years you will be in debt by about $60,000 ($1,000 per month X 60 months). Your debt problem may start gradually, so that you hardly notice. But soon enough it can reach a crisis level.
Assuming your high income will always cover the debt
This is an easy assumption to make especially if your income has gone up substantially in recent years. You may conclude that you will always see large increases in pay and overspend as a result. But if that money ship doesn’t come in and you keep spending as if it’s a sure thing, you could end up drowning in bills you can’t pay.
I can tell you from my own experience that as income rises so do expenses. I’ve noticed this with my own family and with my clients as well. It’s subtle, but it happens.
For example, if you move to a nicer neighborhood that means you have to drive a nicer car. You don’t want that old 1974 Pinto in front of the house anymore do you? Of course not. And since you have new richer friends, you will go to the nicer restaurants they take you to. That’s pricy. This spending spiral goes on and on and doesn’t stop.
Large debts carried over from an earlier time
Even if your finances are currently in balance, you may still be saddled with large debts from earlier in life. This frequently happens after graduating from school, particularly if that included graduate school. But you could also have a large amount of debt from an extended period of unemployment, a business failure, or from a major medical event. If that debt is high enough and/or the interest rate is ridiculously expensive, it may literally take decades to retire that debt.
Lack of orientation toward savings
If you are like me, expenses vary from one month to the next. Some months I spend a lot more than others – and that’s why I keep an adequate amount tucked away in savings.
Rich people who don’t anticipate these non-recurring expenses can often turn to the plastic for a quick (and expensive) bailout. Once they go to that cookie jar, it’s often difficult for them to put the lid back on.
High Debt and Your Credit Score
As your debt level grows, it can have a negative impact on your credit score. This can happen as the number of loan accounts with balances increases, or as your credit utilization ratio rises (the amount of credit card debt you owe, divided by your total amount of credit lines available). Both are factors in calculating your credit score.
Naturally, your credit score will fall even more if you begin to experience late payments as a result of having to stretch your paycheck to cover too many debts. It can lead to a vicious downward cycle that can drop your credit score into the “fair” or even “poor” range.
Once that happens, you’ll begin to see your interest rates rising – which will further stretch your budget. You may also find it more difficult to get fresh credit, which might hasten the day when you will finally have to do something about your debt situation.
There’s one other credit score factor that’s probably more important to high income earners than it is to middle- and lower-income earners. Your credit score could be an important factor in determining if you’re able to get a new job or enter into a new business partnership. The higher your income, the more sensitive a position is likely to be. An employer or partner will consider your credit score.
In this way a debt problem leading to an impaired credit score could also negatively affect your ability to earn a living.
Fixing the High Debt Problem Once and For All
Of course the best solution to this problem is to avoid it in the first place; no matter what, always keep your spending below your income and be conservative. Figure out what you really spend, on average, each month and make sure you earn more than that. If your spending is way out of line, make immediate cuts to bring these two figures in balance.
If you have already landed on the debt treadmill, and your credit is beginning to suffer, it’s time to get help. This is particularly true if you experience a pattern of late payments (especially those of 60 days or more), or have collections or repossessions.
First, implement drastic spending cuts as I suggested above. This may be socially awkward but you’ll get over it and so will your friends. Let’s face it, sooner or later you’re going to have to do this anyway. And it’s far better to get in front of this problem before you are forced to make changes such as being evicted from your home or being forced to liquidate valuable assets in order to pay for a lifestyle you can’t really justify.
After you do that, you need to fix your credit as soon as possible, and then work on developing a comprehensive debt management plan, that will allow you to get out of debt.
Many people are much better at earning a high income than they are at managing their household budgets and their credit standing. If you sense that you are in that situation, you should get your spending in line, and credit help to fix the problem as soon as possible.
There is no shame in asking for help and the sooner you do so the better.
Are you a high-earner with debt problems? What happened? What have you done to address the issue? What else do you need to do now?