Overextension: Definition, Types & Signals
Unfortunately, financial overextension is extremely common in the United States. The rise of e-commerce, credit card rewards programs and payment plans such as buy-now-pay-later have made it very easy to overextend your finances.
Because debt very easily snowballs, overextension can be very difficult to get out of.
What is Overextension?
In finance, overextension refers to a financial situation where an individual or a business is carrying more debt than it can feasibly pay back. Basically, drowning in debt.
The typical definition of overextension is when debt obligations exceed one-third of net income. This figure is significantly above what is recommended by the 20/10 rule — one strategy for debt management.
Types of Overextension
Overextension for Consumers
A consumer paying more in debt repayment than they can afford every month would be considered overextended.
For example, if an individual earns $60,000, any debt payments above $20,000 a year or would make them overextended. The same calculation applies to companies that hold more debt on their balance sheets than their net income.
Consistently carrying a balance on credit cards or missing loan payments costs individuals much more over time and harms their credit scores, making additional credit difficult to obtain.
Lenders must take on additional risk when lending to overextended companies and individuals, which means any additional credit taken out will likely be priced at a higher interest rate.
Overextension for Businesses
Companies can also be overextended, meaning their balance sheets have a poor debt-to-income ratio and they are unable to pay down debt with the level of income the business is taking in.
Sometimes overextension is more than just the fault of mismanaging finances.
Instead, a market downturn can unexpectedly diminish investment returns and consumer spending, leading to a drop in profit and being unable to pay off debts. However, the results are the same.
The cycle of being overextended is similar for both businesses and individuals, but the problems that arise and the solutions differ.
Businesses struggling to pay down debt can see a drop in their creditworthiness rating, similar to consumers, making the ability to secure additional lines of credit more difficult. This also can harm the business’s credibility, which can have immense ripple effects on future profitability.
This cycle worsens for businesses as they may be unable to reinvest in the business or increase capacity to meet a potential surge in demand.
One recent example of overextension can be seen in the cryptocurrency market. In November, crypto exchange FTX filed for Chapter 11 bankruptcy due to concerns of the company being over-leveraged in its own currency.
However, instead of consolidating debt, companies have a few other options for raising capital that are not available to individuals. Namely, companies are able to issue new shares or corporate bonds in order to pay for new expenditures.
Of course, if the company’s creditworthiness and credibility are falling, finding enough new investors may be difficult.
Overextension in Trading
Investment accounts and financial markets can also exhibit signs of overextension. A trader or investor can be overextended when they have excess leverage in account equity.
This typically happens in margin accounts, mostly used for trading futures and options. Margin trading refers to investors borrowing money from a brokerage to purchase stocks or other securities. Similar to having a loan, a margin balance is credit that borrowers must repay with interest.
Traders utilize margin accounts when they anticipate receiving a return great enough to outweigh interest payments.
However, if the investment moves in the opposite direction, that trader will end up on the hook for paying back not only interest but paying back the entire loss of the investment.
If your margin requirement — essentially, collateral — is low, the repayment can be much larger than your initial investment.
If the amount required to pay back is higher than a trader can afford, they may experience forced liquidation and the freezing of their accounts.
3 Signs of Consumer Overextension
The standard definition of overextension is having debt greater than 1/3 of income, but ultimately the standard will vary from individual to individual. For example, wealthy individuals (even with minimal or no income) can take on proportionately more debt without overextending themselves because they are cash rich.
However, regardless of cash balances and cash flow, the following three scenarios are all considered financial red flags.
Spending More Than You’re Paying Off
Many US consumers struggle with credit card debt. According to the 2022 consumer debt data from the Federal Reserve Bank of New York, Americans’ total credit card debt is $925 billion in the third quarter of 2022. That is a 15% annual increase, the largest year-over-year jump in over 20 years.
In addition, 54% of all active credit card accounts carried a balance in the first quarter of 2022. This was the third straight quarter this statistic has risen.
Rising interest rates as well as high inflation levels have diminished the average consumer’s buying power, meaning they have to spend more for the same amount of goods and services.
Steep interest rate hikes are intended to slow inflation by slowing spending, but in the current financial climate, we’ve yet to see a slowdown in spending. For example, Black Friday shopping in 2022 was higher than in previous years — online sales even set a record for spending at over $9 billion.
In addition, the rise of buy-now-pay-later (BNPL) and no-down-payment financing may be a red flag regarding future debt levels in the country. If you find yourself not putting the total amount down upfront and relying on payment plans, this may be a signal that you are living above your means.
Accumulating Late Fees
Being unable to pay bills on time and racking up late fees can be an indication that you have more money going out than is coming in.
Not paying bills on time or consistently paying overdraft fees ends up costing the consumer more over time.
Even the occasional late student loan or mortgage payment can show up on your credit report and hurt your credit score.
If this happens repeatedly, not only will you end up paying much more down the line, but you also are making it more difficult to obtain favorable financing terms on any future debt.
Ignoring Savings Accounts
Failing to save properly for an emergency fund or for retirement planning can be less obvious of an indicator than consistently seeing a negative balance on your bank statements, but it is just as worrisome for your financial health.
Being unable to fund retirement accounts, especially employer-sponsored plans that offer 401(K) matching, is only setting individuals up to continue to overextend themselves.
Without an emergency fund, any surprise expenses — such as falling ill or your car breaking down — will have to be paid out on a credit card or loan, further overextending your finances.
Getting Out of Overextension
One can consider a few options to get oneself out of an overextended financial situation. In many cases, paying down debt faster can be done by improving your financial planning. However, some borrowers may choose to refinance or consolidate their debt.
One option to repay debt quicker is taking out a debt consolidation loan — somewhat counterintuitively, taking out more debt.
Debt consolidation is the act of combining multiple debts into a single loan. While individuals are able to consolidate various types of debt, not all types have the same considerations.
If the majority or all of one’s debt is from credit card spending or in an auto loan, consolidated loans may help one pay all debt more quickly. This is because they have fixed monthly payments and a clear timeline whereas paying only the minimum on a high-interest credit card can take years to pay off.
Consolidating credit card debt can also help to lower interest rates and lower monthly payments. Over time, this will likely also help improve one’s credit score — payment history accounts for 35% of one’s credit score.
On the other hand, it is important to note that personal loan rates are based on the borrower’s credit rating. The lower the credit score, the higher the cost of credit may be. Also, if the borrower misses payments on the consolidated loan, it could potentially set them back even further.
For other types of loans such as student loans and particularly federal student loans, there are additional considerations. Consolidation isn’t the right choice for all borrowers. Being the right candidate for consolidation depends on interest rates, loan types, number of loans and credit score.
For federal student loans, monthly payments may decrease but total repayment may actually take longer which increases the total interest paid over the life of the loan. Additionally, the interest rate could potentially increase or change from a fixed rate to a variate rate.
Consolidating with a private lender also revokes your rights under the federal student loan program including forbearance, deferment, cancellation and income-driven repayment (IDR).
The Bottom Line
Consumers and companies struggling with growing debt face numerous problems beyond paying more over time. While overextending your finances is easy to fall into, it can be quite difficult to dig yourself out of. Over time, it can lead to a decreased credit score and further unfavorable financial terms on future debt obligations.
While financial overextension is common in the US, there are steps individuals can take to manage their finances and stay out of unsustainable debt. Some may consider working with a financial planner to set up a consolidated loan, set up a monthly budget and adequately plan for retirement.