Many aspects of your life are affected by how well-off you feel. Money troubles are a significant source of stress for people and for relationships. Decisions to make purchases and to donate money are based on whether you feel like you are doing well. Election results are driven by whether people feel as though they are doing well financially.
What factors go into making people feel rich?
This question was addressed in a nice paper in the January 2012 issue of Psychological Science by Abigail Sussman and Eldar Shafir.
They had people evaluate pairs of people to determine which one they thought felt richer. Some people had both a high level of assets and a high level of debt. Others had a low level of assets and a low level of debt.
Of course, the actual wealth of a person is determined by the difference between assets and debt. If you have more assets than debt, you have a positive net worth. If you have more debt than assets, you have a negative net worth. Because your overall wealth is determined by the difference between assets and debt, it shouldn't really matter whether you reach that difference by having lots of assets and lots of debt or few assets and little debt.
When the profiles being evaluated had a positive net worth (more assets than debt), they were evaluated as being wealthier when they had low debt (and few assets) than when they had high debt (and many assets). In contrast, when the profiles being evaluated had a negative net worth (more debt than assets), they were evaluated as being wealthier when they had many assets (and very high debt) than when they had few assets (and only a moderately high debt).
Why does this matter?
In another set of studies, people were asked to imagine that they were interested in making a significant purchase, but that they would have to borrow money to make it. People are often in that situation when buying cars, furniture, or appliances. They were shown pairs of profiles like the ones in the study I just described and asked which person would be more likely to borrow money (assuming that each could borrow at the same interest rate).
The results were similar to those in the previous study. When the profiles described people with a positive net worth (more assets than debt) they were more likely to borrow money when they currently had low debt than when they currently had high debt. But, when the profiles described people with negative net worth (more debt than assets), they were more likely to borrow money when they currently had high debt (and also had many assets) than when they had low debt (and also few assets).
That means that financial decisions like the willingness to make a big purchase or to take on more debt are based on people's current feeling of how well off they are. This feeling ought to be based on net worth (assets minus debt). But it isn't.
This perception of wealth can be a particular problem for people who have a negative net worth. If you currently owe more than you own, then you have a bias to focus on your assets. That means that the money you have in the bank and other assets like stocks or home equity may cause you to spend more and to consider taking on even more loans.
As the financial crisis of 2007 showed us, though, assets can evaporate quickly sometimes, which can leave people with high levels of debt and few resources to pay off that debt. So, when considering whether you should borrow more money, focus on your overall net worth. In addition, evaluate how easily your assets could decline in value before saddling yourself with another loan.
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