Is debt your destiny?

Result: You're not thinking clearly about the actual cost of things, because credit transactions skew how you view the money you spend. There is a vast difference between how it feels to pay $10 in cash versus $100 in cash (not to mention the difference to your wallet). But when you sign a slip of paper, spending different amounts feels similar, Soman says.

What does price matter? We have a growing delusion that we don't need to pay attention to price, Soman says, because the number of available payment methods means "price has become so much more ambiguous now."

Maybe you bought those Bose speakers outright, maybe you put them on an installment plan -- "$30 a month! No interest until midnight tomorrow!" -- maybe you used a credit check mailed to you by your bank, or maybe you used five gift cards you got for graduation, or some combination of these options.

Result: Several economic studies have shown that people seem to manage their money -- adding, subtracting, allocating funds -- via a series of mental "accounts." However, this mental accounting can be as creative as Enron's.

For example, if you saved $25 on your electric bill because your dishwasher was broken for a month, you let yourself spend an additional $25 at Payless on shoes. (You didn't gain $25, but you spent as if you did.)

By losing track of what things cost and giving in to the creative accounting preferred by your brain, you make it pathetically easy to spend money you don't have.

• Multimedia: Help! My debt is killing my dream

Hard to escape debt

The worst part of all this is not that we are human, greedy, vulnerable to zero-interest teaser rates and inclined to believe we actually might win the lottery. It's that those of us who are unlucky enough to have fallen into the debt trap are going to have a superhard time getting out.

There are two main hurdles:

1. Your debt costs more than you think.

If you get into, say, $5,000 in debt, it's often because you have told yourself something bird-brained, like "It's only $5,000!"

Wrong, says Jonathan Pond, a Boston planner and the author of "Grow Your Money. "First, you owe interest on that money, and it'll cost $5,330.88 over a year at a 12% interest rate. Second, taxes also have an effect.

We like to think of our salaries in terms of gross instead of net, but because of taxes, we don't have all that money to spend. We tend to think, "Hey, $5,000 is affordable. I make $50,000!" But what we should be thinking is, "Is $5,000 affordable? I bring home $35,000."

2. Debt habits are persistent.

Frank Stafford is a professor of economics at the University of Michigan. He analyzes the Panel Study of Income Data, a long-term look at how nearly 8,000 people have handled their finances over the past 40 years.

He says debt is a rut that is hard to escape.

Studies have found that families who were in poor financial shape -- with little or no savings and with credit card and/or home-equity debt -- were in the same leaky boat 10 years later. That's from a 2005 study, "Grasshoppers, Ants and Pre-Retirement Wealth," which studied families' spending and consumption habits before retirement and then evaluated their financial status 10 years later, during retirement.

The difference is not about income, Stafford says, but about behavior. "Within high- and low-income groups, you see the same two patterns. Some will be reasonable financial managers; the others consistently make more risky, foolish decisions."

Until you become aware of the decisions you're making -- and just how divorced from financial reality they can be -- the pattern of debt simply repeats itself.

Dealing with debt

To get out of debt, you must foster habits that help your brain stay connected to the cash in your wallet.

The convenience of plastic and other not-quite-real payment methods -- shopping online, electronic payments and "buy now, pay later" offers -- are designed to keep you spending money you don't have, by using that uncoupling phenomenon.

It reduces the sense that you're spending real money -- because you aren't. You're using credit, plus paying tax and interest.

Getting out of debt means getting real -- really fast -- about your finances:

Get to know what you really spend. Rather than tracking expenses by the month, Soman recommends his own method: He reviews everything he spends each and every day.

This combats fuzzy spending and fuzzy logic. You won't forget that you dropped $23 at Rite Aid, and you won't pretend those slacks were only $30 when they were $32.40.

Use cash whenever you can. You'll spend less, and you'll be more realistic about what you buy. Soman says if you can't relinquish plastic altogether (few of us can), earmark key purchases that you always pay for with cash. His rule is to buy miscellaneous items (candy at the cash register, for instance) with cash.

My husband and I might use a credit card to buy electronics or expensive home supplies like paint or tools, though only when we have the cash to pay the bill immediately.

Don't play games with your money. We tend to fudge our accounting when we spend (borrowing from Peter to pay Best Buy), so make sure you do reality-based bookkeeping.

If your vacation is canceled and the resort sends you a $2,500 refund, that's money you can spend on something else. If you were planning a $2,500 vacation and decide not to go, that doesn't give you a miraculous $2,500 surplus.

Published Aug. 27, 2008

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