Credit And Debt
On the Financial Independence page we learned that saving money over a long time
period at a good rate of return is the key to financial freedom. That means that you have to
spend less than you earn. Is there anything worse than spending all that you earn? Yes!
Spending more than you earn is much worse. Sometimes credit is needed. For instance,
You need transportation to get to that job that provides your income. The only way to get
that car you need is to get a loan. You don't have the cash. Get the best deal and the
lowest interest rate that you can. No one could buy a home without the use of credit. But
when you charge wants, not things that you really need, at exorbitant interest rates on
credit cards, you are heading for disaster. The rule of 72 also works in reverse. Then it is
working against you.
Learning More
On this page, we will learn how to use credit. We will learn how to stay out of the credit trap
or how to escape it if we've already fallen into it.  All I can do on this page is to give you a
limited overview of some of the key principles that you need to get and stay debt free. To
cover everything, I would need to write several books. I would recommend that you
increase your knowledge by consulting some of the many good books written on the
subject.
The Credit Trap
Lets say you owe $1000 on a credit card at 16%, many cards charge even more. Lets say
you have a number of credit cards with out standing balances and you decide that you
have to start paying some off. You have the one with a $1000 balance at 16% and decide
to tackle that one first. The sad part is you don't even remember what you bought to run
up most of these balances. If you decide to pay off $10 a month, forget it. That won't even
cover the monthly interest charge. The balance will never be paid off. Instead it will actually
grow. Even the credit card company will want a minimum payment that exceeds the interest
by a little bit. The table below shows how long it will take to pay off that $1000 balance at
different payment rates plus the total interest that you will pay. At $15 It will take almost 14
years and you will pay almost 2.5 times the original amount, the original debt plus almost
$1500 in interest.
Years To Pay Off $1000 with 16% Interest
Payment
Years To Pay Off
Total Interest Paid
$15.00
13 years, 11 months
$1488.38
$20.00
7 years
$658.89
$25.00
4 years, 11 months
$438.56
$30.00
3 years, 10 months
$331.36
$35.00
3 years, 2 months
$267.29
$40.00
2 years, 8 months
$224.55
$45.00
2 years, 4 months
$193.93
$50.00
2 years, 1 months
$170.90
Getting Out Of Debt
The table also shows one way to succeed in paying off your credit cards. Just adding $5 to
increase your payment to $20 a month, cuts the payoff time and interest in half. You need
to increase the payment by $10 to$30 to cut the time and interest in half again. You can
see by the table that increasing the amount of the payment after that has much less of an
effect. So heres the plan. Pick one or two credit cards with the lowest balance and the
highest interest rate. Cut up the those cards so you won't be tempted to charge any more
on them. Pick a payment that will pay off the card or cards in about one fourth the time at
one fourth the interest. Continue to pay your minimums on your other debts. When those
are paid use the same method on the next debt that you need to retire.
Using Credit Cards Wisely
If credit cards are so dangerous to our financial health should we own them at all. The
answer is yes if you have the discipline to use them wisely. Try renting a car or booking
into a hotel without a credit card.  You need to have one. Credit cards have a lot of
advantages, if you pay off the balance monthly before interest is added. With a no fee
reward credit card, you get the rewards free if you pay that monthly balance on time.
These rewards can be cash back, free gas, airline miles, credits towards a car purchase or
what ever else the credit card companies can think up to get you to take their card. They
expect that you won't pay off the balance and they will make large profits on  interest. The
card companies also offer special no interest, or low interest for limited time periods of a
year or more, for new customers on purchases and balance transfers. At the end of that
period the interest on the balance goes up to the regular rate. Miss a minimum payment
and the interest jumps up to the maximum rate they are allowed to charge. The smart use
of a credit card has a lot of advantages but use it wrong and it's a financial disaster
No Interest Consumer Loans
A lot of retail businesses will let the consumer make a purchase with no interest due for a
set time period. This could be six months to a year or more. Some times you must make a
minimum payment but sometimes no payment is required. The catch is that the interest is
calculated  through the time period and if you don't pay off the balance before the end
date, then you have to pay the full interest. Also if a minimum payment is required and you
miss one the deal is off and you owe the payments with full interest. These are great deals
to use the businesses money while you enjoy the product but default on the terms and all
the benefits are forfeited. No interest consumer loans are great for people who have the
discipline to use them wisely. They free up your money for other uses like maybe saving it
and earning interest. They are interest free if you meet the terms and pay them off before
interest is due.
Car Loans
The first big purchase that young people make as they are just starting out is a car. A car
loan is a collateral loan. If you fall too far behind in the payments your car gets
repossessed. The most important thing to know is that if they repossess your car, you still
owe them money. They sell the car at a bargain wholesale price to dealers who specialize
in buying repossessed cars. You owe the difference. Even if they tried to get top dollar, a
car devalues so rapidly it's seldom worth what you still owe on it. The best way to make
sure your car has some value left as you pay it off is to take out a loan for the shortest time
possible. A five year loan almost always means your car will be worth less than you owe.
One good thing is that when car companies need to move cars they offer incentives like
cash back, low interest, and no interest loans. The low interest and no interest are usually
for a shorter time. As we have already stated shorter is better if you can afford the higher
payments. Of course these incentives are only available on new cars.
Good Debt
When you borrow money to acquire or build something of value, you are using borrowed
money to create an asset. One example for the average person would be buying a house
to live in. Or you could be buying investment property, like an apartment house. You could
be borrowing to start or acquire a business. We could even consider a student loan as an
investment in your future ability to earn a living an asset. I am going to deal with this type of
borrowing on another page. On this page I am dealing with the common type of consumer
debt. The things that you buy with common consumer debt quickly lose their value and
could never be sold to repay the debt. They are definitely not assets. This is the kind of
debt to avoid or at least minimize.
©2004 - 2005
The Credit Trap