The Fragile Middle Class: Americans in Debt describes a study of households that filed for bankruptcy during the early 1990s and what can be learned from their experiences. The study is based on responses from a sample of about 2,400 case files. Demographic information was collected from respondents, as well as answers to an open-ended question that asked debtors the reason(s) why they had filed for bankruptcy.
According to the authors (Sullivan, Warren, and Westbrook), a middle class lifestyle can be maintained for a while with "smoke and mirrors" (i.e., increased use of credit or "borrowing from Peter to Pay Paul"). Eventually, though, if you continue to spend more than you earn, you will go broke. Between 1979 and 1997, personal bankruptcy filings increased by more than 400%. This is especially striking since this was a time of widespread economic recovery and relative prosperity for many.
The authors warn that the high number of households who file for bankruptcy is an early warning system for all Americans. Anything that causes income to decrease (e.g., job loss) or expenses to increase (e.g., uninsured medical expenses) puts a family at risk for financial difficulty. Changes in the credit industry have also increased affected borrowers' ability to repay what they owe. For example, it is now possible to charge groceries and fast food purchases and receive 125% home equity loans. Many creditors also impose late fees and penalty interest rates of 24% or more on customers who fall behind.
The authors of The Fragile Middle Class found that there were five primary causes of bankruptcy: job loss or income reduction, sickness or injury, divorce, high credit card bills, and housing costs in excess of what a person's income can support. They also found that bankrupt debtors were in "terrible financial condition." On average, they needed two and a half to three year's income in order to repay their debts and their net worth (assets minus debts) was a negative number.
Job-related problems were noted in more than two of three cases. This includes loss of a job and re-employment at a lower wage. Many debtors were back to work when they filed but a period of previous unemployment got them into trouble. Bills that seemed affordable on, say, a $60,000 income were suddenly insurmountable when earnings were cut back to $30,000.
The authors note that many respondents incurred debts close to the limits of their income. Job interruption or loss is a primary cause of bankruptcy because a family's previous debts are mismatched with their current (reduced) income. Some debtors also continued to maintain their former lifestyle on credit cards, further digging themselves into debt.
Another key finding from the study is that every bankruptcy-causing event was a lot worse when a family carried a lot of credit card debt. For a family stretched to the limit, even a relatively minor crisis can put them over the edge. Divorced people are twice as likely as others to file for bankruptcy.
What are the lessons that can be learned from The Fragile Middle Class? Below are six:
Try to keep monthly debt payments below 15% of take-home pay to avoid over-extension before crisis events. In other words, live below your means and spend less than you earn.
Continue to sharpen employment skills to stay "marketable" and avoid major job interruptions.
Accept the financial realities of life events. For example, it may not be possible for either spouse to maintain the family house following a divorce.
Set aside an emergency fund of several months expenses to provide funds during a financial crisis.
Seek help with credit problems early on. Juggling bills and more credit use only makes things worse.
Don't "stretch" to buy an expensive house if mortgage payments, plus other debts, will consume 40% to 50% or more of net household income.