How many of you would purposely spill ten dollars worth of quarters down the grate of a sidewalk? Would you leave your five-dollar bill on a windy open windowsill?
Wallet Woes: The Rule of 72 in reverse.
Which would you prefer, paying a parking or speeding ticket or having strangers (*cough* the banks *cough*) help themselves to money from your wallet? Here’s one of our more popular posts originally released in 2006.
It’s too bad that your credit cards don’t come with the warning “please use common sense when using.” (Not that anybody would stop, but at least you’d have a friendly reminder you were the cause of your own financial demise.) What follows now is the cure to a post holiday or any financial hangover.
It is an often-noted fact that although people faithfully pay down their credit card balances every month it doesn’t diminish as expected.
What the credit card companies don’t want people to remember is that as long as a cardholder carries a balance interest is accruing as you breath. What they calculate will happen is that they will be able to pile on the interest penalties faster than a person can pay down their balance. Guess what! In too many instances people do exactly what they calculate! So you paid $20 on your $300 balance. Now the total you owe is $290 since you have to pay off the interest before the principal. It’s not new math.
Let’s do some bean counting for illustrative purposes. Take two similar debts with the same starting balances of $5000, the same monthly payments of $200. They also have the same interest rate of 8%. One is a car loan, the other a credit card balance
The car will be paid for in 40 months with total interest paid of $488. You will be free of the credit card balance after 8 years with an interest hit of$949 double the interest owed on the car loan!
The car loan is a fixed debt, because the borrower will pay a specified amount of interest and no more. The credit card balance is a revolving debt. Once someone gets spending fast enough it is like an unstoppable revolving door. The cardholder could pay an unlimited amount of interest.
Canadians always ask: What is the interest rate? What will be my monthly payment? Instead they should be asking: What is the total cost to borrow and when is my debt free date? Interest rates are red herrings as shown by this example. Let’s compare a personal loan at 7.75% and a credit card rate of 5.9%. Each has a balance of $7000 and the monthly payments are $200. The borrower will incur interest costs of $961 and $1378 respectively. OK so a few hundred dollars interest is no big deal right? However the debt free date shows why revolving debt is financial bondage. The debt free date for the personal loan is 3.5 years. The borrower will not pay off the lower interest credit card balance for 12 years.
It is a very expensive privilege to carry a balance on a revolving debt. The companies who market credit under many names would rather people forget that fact. Here is more motivation: Which account holders do the companies prefer the most? Answer: The people who always pay only the minimum every month. That is why companies regularly send a steady stream of applications to those households, children and pets included, and never offer to raise the credit limit on accounts that are paid in full each month.
There is a reason it is called the credit trap or destructive debt. If people want to achieve financial independence they must stop allowing lenders to help themselves to money from their wallets. In a future issue I will discuss constructive debt.
While the concepts presented here are sound, the math is atrocious.
$5,000 paid off in $200 payments will be paid off in 29 months no matter whether you’re paying your car dealer or your credit card company. It will cost you $488 in interest which is the only part of that example the author got right.
$7,000 paid off in $200 payments will be paid off in 40 months at 5.9% interest at a cost of $701
The ‘personal loan’ calculations are right, 41 months at a cost of $961.
Revolving debt can be very dangerous, but it refers ONLY to your choice to put more debt on the card. If you are making monthly payments and NOT using the card, then there is no difference in the types of loans.
Take the author’s advice and don’t keep using your credit card when you’re trying to get out of debt, but go somewhere else for help with your math homework.
I think what I forgot to put in was that car loans typically aren’t 19.9%. Actually, maybe it was because credit cards are compounded daily…..Thanks for the eyes.
both good points, but you specify in your example that both interest rates were 8%
…and daily compounding doesn’t make that much difference, you would lump it in with rounding error when you’re measuring in years.
interest on revolving credit is calculated more frequently often daily. Therefore a revolving debt with the same interest rate as a fixed debt will incur more interest and take longer to pay off.
Often if a cardholder is even one day late or does not pay off the balance on a revolving debt interest is charged on the whole amount. For example of you pay $450 off a $500 credit card balance interest will be charged on the full $500.
I am slow, (seriously this isnt a joke) tell me where my math is wrong (because I am overlooking something:
“Take two similar debts with the same starting balances of $5000, the same monthly payments of $200. They also have the same interest rate of 8%”
so we have Balance of $5000, payment of $200 and a rate of .08 correct.
5000/200=25 right, so shouldn’t it take 25 months to pay this off (and that would be the ‘principal’ correct?)
Also, and this is where I am really confused (once again not a joke) but where does $488 interest come from? 5000*.08=400
So if this holds true then one should borrow $5000 and pay $5400 back in 25 months (I know it cant be this simple, that is why I am asking for help)
lastly (and this is a add on) for the credit card, according to the rule of 72, the balance will double in 9 years if not paid in full correct? 72/8=9.
If someone could explain this it would truly be a great help, so far nothing I have read or anyone I have spoken to has made this stuff clear.
I forgot to account for the interest payment in the 25 months, if 25 is for the principal, then how long should the interest be (as I assume total interest should be $400). Maybe I should just ask how interest works.
You’re off to a good start. If you owe $5,000 and are charged 8% interest, then you will pay back $5,000 + $400 or $5,400. This is called simple interest. Unfortunately lenders add a new concept called ‘compounding’. They will calculate your interest payments each year or each month or each day and add that to your balance. We’ll use monthly compounding because most accounts work on a monthly cycle.
So we start by computing the monthly interest rate. If you’re paying 8% annually, then you divide by 12 to calculate the monthly interest.
The first month you owe $5,000 plus the monthly interest of 5000 x (8/12) = 33.35
5,033.35 – 200 leaves a balance of 4,833.35 and you have paid $33.35 in interest so far.
month 2: 4,833.35 * (8/12) = 32.22
Add interest & subtract payment and your new balance is $4,665.57 (rounded off)
and you’ve paid $65.57 in interest so far.
Keep going & you’ll find that because the balance increase a little bit before you make the payment it takes 29 months to pay off and will cost you a total of $488 in interest.
hopefully this will help get you started. Search for ‘compound interest’ and ‘amortization table’ to explore more.