In a (much) earlier post, we talked about taking advantage of the miracle of compounding interest. There may be no more important financial lesson out there – so don’t be surprised if it comes up again.
Yet with so much recent press paid towards the subprime crisis and who’s to blame, now is an excellent opportunity to discuss the importance of understanding why expensive debt is so costly.
You: That sounds redundant.
It is redundant. I’m glad you caught that. Care to explain why it is then that people forget the true cost of their potential new debt when the are actually borrowing the money?
You: Um –
I’m stumped too. Continuing on, do you realize that a credit card with a 25 percent APR featuring daily compounding actually costs more than 28 percent?
You: No. What does that mean for me?
It means you need to make paying back credit card debt a high priority. Take a look at Jennifer’s credit card debt. The following figures are listed prominently in the “account summary” section of the credit card bill she just received:
new balance: $ 7,016
minimum payment: $ 140
If she always makes the minimum payment on time, how long will it take Jennifer to pay off this credit card?
You: I don’t know.
Smart fellow. You’re right—we can’t tell. Not yet. The answer does not appear anywhere on the statement. However, if you look carefully at some of the fine print, you will find the annual percentage yield. This is the interest rate charged. In Jennifer’s case, this rate is 17.24 percent. Now, if you are willing to do some math, you can calculate how long it will take Jennifer to pay off her debt by making on-time minimum payments.
You: Well, let’s see. If you divide her $7,016 debt by that $140 minimum payment, you get about 50. So 50 payments will cover the principal she owes. But there’s also the interest cost. That would probably add another year. So 50 months is a little over 4 years, then add another year. I’d say between 5 and 6 years. Wow, that’s a long time.
A well-thought argument.
You: Thanks.
But it’s completely wrong. Of Jennifer’s first $140 payment, less than $40 is applied to principal. The rest is used just to pay interest. This leads to some serious ugliness: paying only the minimum payment actually means over 45 years of payments for Jennifer. Forty-five years! Over that time, in addition to the $7,016 of debt, she will pay about $17,000 in interest. Can you see why paying only the minimum balance is not a long-term solution to credit card debt?
You: It’s as if the miracle of compounding interest is being used against me.
That’s exactly what is happening! It is being used for evil. Making only minimum payments is the financial equivalent of endlessly paying interest on items you can no longer remember purchasing. The sooner you accept this, the sooner you will find a way to pay down any credit card balance and begin living a life Beyond Paycheck to Paycheck.
“personal finance” 
“financial education”
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