As
it relates to their personal
finances, credit card debt
is one of the most passively destructive forces Americans face. To me, credit card debt is
simply a financial
obligation owed to a bank or credit card issuer, and is destructive two
for
major reasons. First,
in many cases, it allows
the borrower to purchase items that he currently does not have enough
cash to
pay for. Second,
the items purchased
often carry an interest charge if the entire purchase balance is not
paid for
by the end of a specific grace period.
In
most cases, the interest compounds until the debt in repaid in full. This compounding action of
the debt means
that interest in accrued (i.e. charged) on top of the interest that
accrued in
an earlier period. Said
another way, a
consumer pays interest on the interest that was charged to him
last
month. Conversely,
in a savings account,
interest accumulates on top of the interest that was paid to him last
month. Hence, we
are given the very
popular term of compound interest
Credit
card debt is generally broken
down into two components,
principal and interest. It
helps to
think about these two components separately before thinking about them
together. Principal
is the cost of an item
that was purchased. For
example, if you
bought a refrigerator on credit for $500, then your principal on this
loan is
$500. If you do not
pay the credit card
issuer, in full, by the end of the grace period, then you will be
charged
interest above and beyond the $500 purchase price.
Let’s say that it takes you one year (12
monthly payments) to pay the credit card issuer for the refrigerator,
and that
by the time the refrigerator is fully paid for, you paid an additional
$100 in
interest. In this
example, you paid $500
in principal and $100 in interest for a total cost of $600. The refrigerator cost you
20% ($100/$500)
more than it would have had you paid cash.
If you were able to pay cash, the extra $100 could have
been used for
anything else you might have needed or put in a saving account where
interest
would have been paid to you.
The
above example is a basic illustration of how debt really
exaggerates the cost of consumer purchases and why is should almost
always be
avoided. Many
Americans have debt far
beyond the $500 level used in the example above; therefore, they have
interest
accruing at a much higher level than $100 per year.
So
where did that $100 go?
Well, it partly went to the bank that issued your card and
partly to “someone”
with more money than you. That
“someone”
likely figured how to save more money than he needed to live on. Then, he gave his excess
funds to the bank,
and the bank lent it to you. For
example, that “someone” might be getting paid 5.0%
interest on his savings
account, while you are paying 20.0% on the refrigerator purchase. The 15.0% difference is
the
banks margin. They
need margin to pay for, among many
expenses, their employees’ wages and solicitation mailings to
people like you.
Do
you like the fact that you are
giving money to someone
that likely already has more than you?
Do
you like the fact that some “rich guy” is earning
interest off your hard work? This
rich guy is like a second boss who you
are working for (and you thought you only had one boss at work). The bottom line is - you
shouldn’t like
giving rich people more money, especially yours.
So,
if you’re in debt, how
do you get out of it? The
answer is to simply stop buying things
you don’t need. Necessities,
for you and
your family, include food, clothes, healthcare and a warm home (or
apartment). Beyond
that, most purchases are simply
wants. When you are
in debt, one of your
greatest wants should be to get out of debt.
If you don’t, you will keep paying that rich guy
and the bank $100 too
much for a refrigerator (or fill in the blank).
Once
all of your necessities are
covered, repaying debt
should be a high priority. Always
start
by paying as much as you can against the credit card with the highest
interest
rate, even if this means only making the minimum payment on lower
interest rate
cards. Your goal is
to pay off the
highest rated cards first, and then move on to the next highest.
Now,
I am not advising that you put
yourself on such an
aggressive repayment schedule that you have no extra money to enjoy
life a
little. Living a
balanced life is
important, even when
you’re in debt. What
I am
advocating is that you
make debt repayment a high priority in your financial life, but not
higher than
taking care of loved ones or at the expense of any necessities in your
own
life.
Once
you start to pay down debt, you
will likely feel more
relaxed and in control of your life.
You
will soon find that you have more money that you did previously, which
will be
due to two reasons. One
– you’re not buying
things you don’t need (i.e. you’re not increasing
your principal balance). Two
– you’re not accruing interest on that
principal.
There
are many attractive uses for
your new found
money. You can
support a charity that is
meaningful to you, help out family members that are strapped, increase
your
retirement savings, and, of course, buy yourself something you
“want”. Once
you are out of debt, your wants should
always be paid for in cash. If
you use a
credit card for convenience, be sure to pay the balance in
full
each
billing cycle; therefore, you will never be carrying a balance with
which
interest would accrue.
I
got out of debt about three years
ago, and it was a very
liberating and gratifying experience.
Now,
I don’t make
any purchases that I can’t afford to pay for in full by the
time
the credit
card bill is due. I
still live in an
apartment because I can’t afford to buy a house outright
(i.e. without a
loan). There are
many financial gurus
that will make a case for the tax benefit one gets from home ownership. To me, I would rather have
the freedom of
living without a mortgage, even if this is not the most financially
effective
strategy. Peace of
mind is more
important to me than the partially offsetting tax savings I would
receive for home ownership.