The Debt Spiral - How Close Are You To Bankruptcy? The Answer May Surprise You

Think you have your finances under control; you may be a lot closer to bankruptcy than you may think. It's incredibly important that you understand credit and how it can affect you; a lot of people learn this secret about debt at some point, unfortunately, it's usually too late by the time that happens. Listen, not many of us ignore our finances because we have money to throw out the window, and because of this we need to take a proactive approach to our finances before they take control of us.

A little bit of debt is fine, it's actually a good thing, but it can easily get away from you and spiral out of control, and this spiral can begin a whole lot sooner than you may think, even if you don't have a lot of it. A quick example should suffice to drive home this point.

Kelly is 23, she's graduating from college and soon she'll be ready to take the plunge into the job market. Even though she managed her finances well and had a full-time job throughout college, she still racked up $25,000 in student loan debt. She calculated what her payments would be and found that, as long as she got a job relatively quick, she shouldn't have a problem making the low monthly payments on her student loans. She only opened a credit card so that she'd have access to funds in case of an emergency; although she used the card through college, she managed to pay off the balance every month.

Kelly was recently offered her dream job in Southern California, but it's a long way from her home in Ohio. She decides to accept the offer because, although she may have to charge some moving expenses, she'll be able to pay the balance off in time with the salary her company offered.

She moves back home after college as she isn't scheduled to start her new job for a couple months. She's unable to find a job to hold her over for those couple months because she's only available for such a short time. She's not too worried about it because she doesnt have a whole lot of expenses and she can sell some of her old college books to hold her over. Two months later, moving day has arrived, but she doesn't have enough to cover all the expenses; out comes the charge card. She manages to make the move across country charging only $1,000 to her credit card.

She has some other expenses to take care of when she arrives in California; she needs a deposit and first month's rent for an apartment and gets a cash advance on her credit card to cover that; a total of $1,900. Total credit card balance: $2,900. Her monthly minimum payments aren't too bad and she's able to cover her expenses, but needs to start getting paid before she can really make a significant impact on her debt.

She's a smart, frugal consumer, but still needs to buy some necessities (and maybe a few non-necessities) for the new pad. She's been told that she shouldn't let her credit card balances go over 50% of the limits, her current credit limit is $6,000, so she opens another credit card account for her household items; she has a 740 credit score and has no trouble opening a 0% intro APR credit card account and charges $1,500. Total credit card balance: $4,400. Unfortunately the car she's owned for years now craps out on her and she has to buy a new one; she gets an $8,000 auto loan for a reasonably priced, reliable ride to work.

Although her monthly payments have gone up significantly since before she moved to California, she's bringing home $3,000 a month after taxes and isn't having a whole lot of trouble making extra payments on all of her debts.

Six months later things take a turn for the worse, the market takes a nose dive and her company makes cuts to try and stay afloat; unfortunately that leaves her jobless. She's managed to pay her credit card balances down to $1,500, but hasn't saved any money for a rainy day, and it's getting pretty wet out there. Kelly has to charge her living expenses, including her rent, until she finds another job. Since the market turned, none of the companies in Kelly's industry are hiring, and it takes her 3 months just to secure an average job at an average company; three month's worth of living expenses go onto the credit card. Although she got her credit card balances down to $1,500, she's now racked up $5,900 to cover three months' living expenses. Kelly's now at about 40% of her limit on her first card and over 50% on her 0% intro APR card and her credit score drops to 700 because of this. With all the madness of searching for a new job and trying to get her bills paid, she forgets to pay her 0% APR credit card bill and she receives a notification that they've canceled her introductory period and raised the interest rate to 20%. In light of the missed payment and her lower score, the company re-evaluates her credit limit and lowers it to $3,000, bringing her balance to 100% of the limit; her credit score drops again to 680 as a result.

She makes a lot less at her new company than before and, although her new paycheck's covering the bills, she doesn't have anything left over. Kelly's always been someone to plan ahead and, being in the precarious situation she's in now, decides to go for a personal loan from her bank to hold her over until she's able to get back on her feet again. The bank denies her; her credit score's dropped to 680, she's got a late credit card payment on her record, and her overall credit balance is only $1,000 from the limit.

Murphy's law always rears its ugly head at the worst time and this case is no different; her car breaks down on the way to work one day. The repairs are going to cost $1,000 and now she's really in trouble; both credit cards are maxed out and her credit score's dropped significantly since college. For the first time in her life, Kelly cant find anyone willing to give her another credit card or loan. It's panic time; she needs to find another credit line somewhere, anywhere, because if any financial problem comes up at all, she's not going to be able to make it. Her search leads her to complete credit applications with ten companies, every single one of which denies her application for credit. The side effect of all this searching has resulted in her credit score dropping down to 630 due to excessive inquiries. She can't believe where she's at now and wonders how a girl who's committed to financial responsibility her whole life could end up in such a situation; all the stress is really wearing on her and she starts having panic attacks as a result. Her doctor prescribes an anti-anxiety medication to help her manage the stress during this tough period in her life, however, she's notified that her insurance won't cover the expense because she saw a psychologist when she was 16 for stress related to her parent's divorce. Now she's forced to foot the $130 a month medication bill; she's literally searching for change in the seat cushion to fill her gas tank.

Kelly's a smart girl, she's managed her debt since she was old enough to get a credit card and now she's exhausted every possible means to pay her bills; her credit cards are completely maxed out, her monthly minimum debt payments are more than she can handle, and she's spent every last dime she had in checking. She's frustrated because she can't believe that she spent her whole life up to this point trying to avoid getting into this exact situation. Now she's been taken on a roller coaster ride, but she's not alone. A huge number of otherwise responsible adults go on this ride every year; I call it the debt spiral.

Kelly could have avoided this situation entirely, but would have had to have an understanding of debt that most people just don't have. I'll go over the details of exactly what Kelly should have known that would have helped her to understand exactly how far away she really was from the perilous situation she's in now in Part II of the Debt Spiral Series on my blog, Truthful Lending dot Com (link below).

John Crenshaw is an accomplished mortgage advisor, self improvement expert and writer. True financial freedom comes from taking charge of your life and understanding the tips that rich people use for making the most of their money. Check out John's blog for more information on personal finance and mortgages from John Crenshaw.

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