The Real Cost of Credit Card Debt

When it comes time to assess your financial health, nothing is more important than seeing an itemized monthly budget in black and white - every single item that you spend money on - and what % of your income it represents. Seeing it all on one page makes it real, undeniable, and inescapable. You have to deal with it, and that's a good thing. You can't make intelligent decisions until you have the cold, hard facts in hand, and one of the most important budget items to examine is debt.

Debt can be a serious threat to your financial security because it is a commitment that keeps you from making the most of your money. What you spend on debt payments could instead be saved for an emergency fund, retirement, or a college education. While the amount of debt that you have can directly affect your financial health, all debt is not created equal. There are many reasons to have debt, some wise, some unwise, and it can affect your financial situation in various ways. A mortgage, for example, is often considered to be "acceptable" debt (payments should be no more than 28% of your income) since it involves a fixed cost and a low interest rate. The cost of carrying this type of debt may be partially offset (hopefully) by income tax deductions on the interest paid and real estate taxes, and appreciation in the value of the property. Also, at the end of the mortgage you still have a valuable asset.

An example of "unacceptable" debt is credit card debt. This is a common item in many budgets but it's important to know the true cost. According to the Federal Reserve, 55% of households carry an average monthly credit card balance of ~$5,000. This may seem like a huge amount to some, and an insignificant amount to others, but the cost to everyone is the same. Carrying a credit card balance from month to month, however prevalent in our society, is never advantageous. Not only do interest charges continually increase the cost of what has already been purchased, but the required monthly payments restrict your ability to use that money more productively.

Consider this example: If you had a $5,000 balance (with 21% interest) and only paid the minimum required, it would take over 23 years to pay it off, and would cost $8,300 in interest alone (more than 1.6 times your original purchase)!

But let's say that you can do better, and intend to pay $200/month towards your balance. It would still take more than 2.8 years to pay off, and cost $1,633 in interest charges. This adds almost 33% to the original cost of what you purchased. Even if the item was "good deal" when you bought it, it's not anymore. Will you even still own the item(s) after three years? Was it worth the almost 3 year monthly commitment?

Had you not carried that balance for so long, but had paid it off within 30 days, you would have $1,600 in your pocket. If you had invested only the interest portion of those payments for the same amount of time (with a 7% return) you would have ~$1,900. After 34 months, would you rather lose $1,600 with nothing to show for it, or have $1,900 in hand? That's a $3,500 difference that shouldn't be easily dismissed.

Carrying an average credit card balance of $5,000 from age 30 to age 60 (not uncommon these days) could easily cost over $17,000 in interest alone, and $65,000 in lost investment dollars. You just lost $82,000. Was it worth it? Remember, this only involves the interest paid. You could have still purchased everything that you wanted, not depriving yourself of anything, and also saved $82,000! That's not a small amount of money to anyone.

Even better, if you invested $200/month from age 30 until retirement at age 65, you could end up with close to $360,000 (assuming a 7% return). That's a tidy sum for a relatively small savings goal. With all the reports about how little people have saved for retirement, it doesn't seem all that hard to save quite a bit if you get your priorities straight early on (or even later!). Always make sure that you understand the impact, current and future, of your decisions.

The next time you reach for your credit card (and don't intend to pay the balance within 30 days), think of the real cost of whatever it is that you're purchasing. By carrying a balance, you could easily add 33%, or more, to the cost of your purchase. Does it still seem like a good value? Would you be happier overspending for that item, or actually making a profit off of the money that is not spent? Of course, there will always be discretionary items that you would like to purchase, and there's nothing wrong with that. Just remember that it's always best to pay cash, or at least pay the items off after 30 days, rather than having an unnecessary monthly financial commitment that only adds to the cost.

Ask yourself - why is it okay to buy something with money that you don't have yet? If it's not an emergency (fashion emergencies don't count!) just don't do it. Self restraint is highly underappreciated but it pays big dividends when practiced. Pay off all credit card debt as soon as possible, relieve that stress, and give yourself the best opportunity to control your destiny and achieve financial security. A goal to strive for - a mortgage should be your only debt by the time you turn 50. Consider it a gift to yourself, and enjoy the freedom.

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