Accredited investors understand how to use debt in their favor to achieve wealth. They have a keen understanding of how compounding of interest can work for them (with investments) and against them (with debt). These investors understand that credit card debt can be one of the worst types of debt if not paid off quickly. This type of debt is designed to extract the most amount of money over the longest period of time possible from the card owner. An astute investor would only use this type of debt for short term opportunities with the intent of paying off the card as soon as possible (likely in a month or two) to prevent overpaying for the item the funds were borrowed for. Lets now look at an example to illustrate how bad credit cards are for long term debt.
Long term cost of credit card debt
Assume you went to an electronics store and saw the price tag of $2,000 on a very nice large TV that would go perfectly with your high def entertainment center. What would you do to get that TV today if you didn’t have the money? Would you tell the clerk “I will make monthly payments to you totaling $8,183.46 over 26 years if you let me have that TV today?” Would that be a good option? Is a $2,000 TV worth $8,183.46 in long term debt? Consider also that you are making a monthly payment on this debt for 26 years that takes away cash that you could have been using for other purposes all that time while paying the credit card company over four times what the TV initially cost. You lose out in two ways: 1.) the loss of monthly cash flow due to the monthly minimum credit card payment that initially starts at $40 per month payment and decreases over the 26 years, and 2.) the loss of $6,183.46 ($8,183.46 total paid – $2,000 actual cost of the TV) that could have been invested to make money rather than be paid to the credit card company.
Throughout this article, I am going to quote numbers that come from a crude credit card payment calculator I created using Microsoft Excel. The numbers may not be exactly accurate, but they are close enough to illustrate my points being made.
Credit cards are very profitable
Ever wonder why you get so many “you have been approved for” letters in the mail about some new credit card? Also, many of the same companies send out letters repeatedly to you. How can they afford to do this to so many people repeatedly? They can afford it because credit cards are VERY profitable for people who make their payments faithfully. In fact, people of questionable credit are even sought by come companies since they can charge higher interest rates due to the higher risk. If these people make their payments at the higher interest rate to try and build or repair their credit history, then the company really has a profitable situation. Faithful payers for very high interest loans are the ultimate money machine for these companies.
How credit card debt works
Most of us are used to a fixed rate loan where you borrow a set amount at some interest rate to be paid back over a period of time resulting in a flat monthly payment. Each month, more of the principle is paid off while the interest charged on this decrease also decreases. Eventually toward the end of the loan, most of the payment goes toward the principle and very little goes toward interest. In my own terminology, I call this a principle focused loan since the purpose of the loan is to increase the amount paid toward principle as the loan matures. This type of loan is in the interest of the borrower since the goal is to get the loan paid as fast as possible without giving too much toward interest.
On the other hand, the purpose of credit card debt is to keep from paying toward the principle and increase the amount of money paid toward interest. Every month the credit card company changes the minimum payment due to be a set percentage of the remaining debt balance, usually 2 to 3 percent of the balance due. As the balance is paid off, the minimum payment decreases. Therefore, since the payment due continually decreases as the balance decreases, it takes many years before the payment would get you to zero. All the while, most of the payment each month goes toward interest and very little toward the principle (pay down of the debt). I call this an interest focused loan. This type of loan is in the interest of the lender or credit card company since the goal is to continue receiving the largest amount of interest payments from the borrower for as long as possible. It is not in the best interest of the credit card company to get these loans paid off since their income from interest would then stop.
Example to illustrate the perpetual interest payment structure of credit card debt
Continuing the $2,000 TV purchase example earlier, assume the credit card has an annual 19.99% interest rate and a minimum payment percentage of 2% and a absolute minimum payment of $20.
In your first month, the minimum payment would be 2% of $2,000 or $40 with $33.32 of that going to interest (monthly portion of annual 19.99% interest rate on the $2,000 balance due). By the beginning of the fifth year, your monthly minimum payment would be $32.83 with $27.35 going toward interest and a balance due of $1,641.58. Over that five year period, you would only have paid $358.42 toward debt while paying $1,786.74 of total interest. Your total payments would be $2,145.16, which is already more than the $2,000 TV and you still owe another $1,641.58 before the debt is paid off. After the 10th year, your monthly minimum payment would be $25.80 with $21.49 going toward interest and a balance due of $1,290.02. Over that ten year period, you would only have paid $709.98 toward debt while paying $3,539.29 of total interest. Your total payments made over the five years would be $4,249.27, which is over twice the $2,000 TV price. In addition, you still owe $1,290.02, which means you have not even paid off half of the $2,000 initially borrowed for the TV at the end of 10 years. The bank has made $3,539.29 in interest from you and will still get at least another $1,290.02 should you pay the balance in full. They know you are unlikely to pay the balance due so they can look forward to getting much more money from you for an additional 16 years!
Compare with a fixed rate loan
Now consider a fixed rate loan for the $2,000 at the same 19.99% annual interest rate over a 10 year period. In this case, the monthly payment would be a set $38.64 for the full 10 years. Lets now make comparison’s with the above credit card example. After the fifth year, the monthly $38.64 payment would send $24.30 to interest and $14.34 to principle. Total interest paid would be $1,776.95 as compared with $1,786.74 using credit card minimum payments. However, the remaining balance due on this fixed rate loan is $1,458.68 verses $1,641.58 for credit card debt. The difference becomes much more pronounced after 10 years. At that time, the loan is paid off. Total interest paid is $2,636.54 with this loan verses $3,539.29 using credit card minimum payments. In addition, you still owe $1,290.02 on the credit card where the fixed rate loan is paid off. The bank made a total of $2,636.54 from you on the fixed rate loan, but will make $6,183.46 in interest from you using minimum payments on the credit card.
Don’t blame the credit card issuer
Remember, it is your choice to make the minimum payment or to pay off the balance due. If you continue making minimum payments, then don’t blame the credit card company for “ripping you off”. They are in the business of making money in a free enterprise capitalistic economy. As long as people continue making minimum payments, this is a valid way to generate income for these companies.
Next week’s continuation
In next week’s article I describe two strategies to accelerate paying off your credit card debts. In two weeks I’ll talk about applying these two strategies and another strategy to elilminate all of your debts.
Copyright 2008 Ole Cram, President of Marcobe Investments, Inc.
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