FUNDAMENTAL TRUTH #82: “Too much debt is always a bad thing.” – Old Pithy

Posted by PITHOCRATES - September 6th, 2011

Paying Interest on Interest makes Credit Card Balances Soar

Some of us have been there.  Some of us are there now.  And hopefully some will learn this painful lesson without ever having to be there.  I’m talking about those seductive credit sirensCredit cards.  Who lure us with their access to a life we cannot yet afford.  Only to destroy us when we’re fully within their grasp.

For those who have lived it, I apologize for evoking the spirits of memories past.  For those feeling the full weight of despair and hopelessness now, hang in there.  You’ll get through.  It may be painful.  But time will mitigate that pain.  Just think of a point in time past the painful times.  Where it will be better.

It happens before we realize it.  You’re charging a little each month.  It doesn’t seem like a lot.  But it adds up.  Worse, the interest really adds up.  For two reasons.  High interest rates.  And because that interest is rolled into your outstanding balance.  So you’re paying interest on interest.  Which makes those balances soar.

The Credit Card Companies have High Interest Rates because it’s Unsecured Credit

The easiest way to look at this is with numbers.  So let’s do that.  Let’s look at a 5 year period.  Each year say you charge $6,000.  That’s $500 each month.  Or about $115 per week.  Charge a couple of dinners and you’re almost there already.  Buy some clothes.  Buy a round of drinks after work.  Say you buy a TV during the year.  Or some other toy.  Like a tablet PC.  Or charge a vacation.  It will add up faster than you ever thought possible.  Things are good at first.  Sure, you’re running a little deficit.  But you’re able to do things or have things you otherwise couldn’t.  Besides, it’s not that much really.  And you can stop at any time.

But it’s that interest that will get you.  Say your card has an APR of 29%.  That’s a huge rate.  Why is it so high?  Because it’s unsecured credit. When you get a mortgage and you default on your payments, the bank gets your house.  The credit card companies have no such claim.  All they have is your promise to pay them back.  And a lot don’t.  Hence the high APR.  To pay for those who don’t repay what they borrow.

Let’s assume your minimum monthly payment is a consistent 5% of your outstanding balance.  For simplicity, we’ll calculate interest on the beginning balance plus the new charges for that year.  That 5 year period looks something like this:

High Credit Card Balances require Austerity, Spending Cuts and a Second Job

In these 5 years you charge $30,000.  But your outstanding balance is almost twice that.  Because of paying interest on interest.  This is what really makes that monthly payment increase.  Which wasn’t too bad in the first year or so.  But by the third year you’re feeling it.  You’re finding it difficult to pay all your bills.  By the fourth year you’re struggling to make your house payment.  By the fifth year the collection agencies are calling you.

So you cut up your credit cards.  And start an austerity program.  Cut spending.  No more cable.  Cell phone.  Maybe take a part-time job.  You think you stopped the bleeding at least.  Now it’s just a matter of paying down that balance.  But it isn’t quite like that.  Because you’re still paying interest on interest.  So even though you’re not charging anymore, your balance is still increasing.  Only worse now.  So let’s take a look at the next 5 years.

That second job you took to help pay down this balance can’t stop it from growing.  Even with no new additional charges.  And that monthly payment just continues to grow.  It’s a losing battle.  However hard you try your balance and monthly payment continue to grow.  To unsustainable levels.

High Credit Card Balances makes Real Income Decline

Let’s say at the beginning of this 10 year period you earn $30,000.  And each year you get a 3% raise.  Enough to keep you ahead of inflation.  With a little left over.  During good economic times, at least.  Now let’s look at a simple graph.  Showing your income.  And your income less your credit card payments.  For this 10 year period.

Your income may have steady growth, but it’s all going to the credit cards.  While income rises 3% your ‘net’ income is flat.  Factor in inflation and this is a decline in real income.  Makes it hard to raise a family.  When your costs go up.  But your income doesn’t.  And it’s far worse than this graph indicates.

Credit Card Balances tend to Increase at a Rate greater than your Income

You may be stressing to just pay your bills.  Which is harder to do each year because of that growing credit card balance.  And nothing will get better until that balance goes down.  But that’s easier said than done.  Because of paying interest on interest.  You may run to get ahead of this increasing balance.  But it’s a race you will lose.  Because that balance will increase at a far greater rate than your income.  As shown here:

After the fifth year your options are limited.  Severe austerity won’t help.  A part time job won’t help.  The numbers are by then just too big.  If you’re married and have a grandparent that can provide free child care, two full-time incomes may help.  Provided your spouse has high income potential.

But chances are you won’t get this far in the graph.  Your credit will probably be shot by the fifth or sixth year.  The collections agencies will be telling you to sell your assets (tools, cars, wedding wings, etc.).  That won’t be pleasant.  But there is some light at this end of the tunnel.  Once they throw you to collections, there should be no more interest charges.  So your credit will be shot.  But you’ll at least be paying down a falling balance.

Living beyond your Means leads to Austerity then Bankruptcy

Credit cards are convenient.  But you should use them as cash.  Pay them off in full every month.  Because living beyond your means will only saddle you with debt.  And too much debt is always a bad thing.  The bigger the debt the more of your money goes to paying the interest on that debt.  Leaving less for the things you currently enjoy.  That you will have to give up so you can pay that interest.

And if your debt grows past the point of no return bankruptcy may be your only option.  And everything bad that comes with it.  A bad credit rating.  Making it more difficult to buy a car.  Or a house.  Even getting a store credit card so you can buy your kid a computer for school.  Something you could afford in 6 monthly payments.  In one of those 6 months same as cash offers.  But not cash out of pocket.

It is inevitable.  When it comes to living beyond your means.  Austerity.  Then bankruptcy.  Unless you’re the government.  And can simply print money.  But that can only postpone the inevitable.  And the longer you postpone the inevitable, the more painful the inevitable will be.  Whether you’re an individual.  Or a government.

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