Here’s a shocking fact: Visa makes around $20 Billion dollars a year.
Mastercard is right on their heels with $15 Billion. A few years ago, American Express came within spitting distance of making $40 Billion in a single year.
There’s a lot of money in issuing credit. How are these companies making their money? Off the people using their cards.
Why do consumers hand over such astronomical sums to these companies every year? The answer seems to be that in the short term credit cards seem like an impossibly good deal. But in the long run, they are a dangerous trap. Let’s take a look at how people get sucked in.
The “Magic” of Minimum Payments
Let’s say you’ve just landed your first real job and moved into a place of your own.
Unfortunately, you break the most important rule in personal finance and spend more than you earn. Not by much. Your job brings home $3,000 a month and you spend $3,150.
Yo’re overspending by just $150 a month. That’s around $5 a day.
Not having enough money in the bank to cover your expenses, you put the extra $150 on a credit card with an 18.9% interest rate.
The thing about credit cards is that they don’t make you pay them back for all the stuff you buy. At least not all at once. They send you a bill for a minimum payment. Usually the minimum payment is calculated as a small percent of your balance. Let’s say your credit card charges either 4% or $15 for the minimum fee, whichever is larger.
So you’ve spent $150 and a bill comes in the mail…for $15.
What a relief! You spent $150 that you didn’t have and the only consequence is that a bill comes in next month for $15.
What’s the deal?
The Math Behind Your First Bill
Your credit card normally requires a minimum payment of 4% of your balance. But if 4% of your balance is less than $15, you pay $15.
You spent $150 and 4% would be $6. That’s lower than $15, so your bill is $15.
The interest rate on your card is 18.9%. To calculate the interest you owe, multiply your balance by the interest rate and divide by 12.
Why divide by 12? Because interest rates are usually annual but the payments are due monthly. That means multiplying your balance by your interest rate gives you how much interest you’d owe over a full year. Dividing by 12 gives you how much is due this month.
So in our case: ($150 * .189)/12 = $2.36
It really doesn’t look too bad does it?
Since we know your total payment is $15, we can subtract your interest payment to find out how much of the principal you are paying down:
$15 – $2.36 = $12.64
So by paying $12.64 in principal, your balance is going down to $137.36 right?
The Vicious Cycle Begins
If you haven’t spotted the problem yet, here it is: You were already spending more than you earned and now you’ve added an extra expense.
What’s worse, you were spared the consequences of not running a balanced budget. If you had just run out of money, you would have learned your lesson. Instead, the credit card company picked up the tab. When you got the bill for $15, it felt like you got away with something.
There’s no urgency to pay off your debt because the credit card seems like an elegant solution to your cash flow problem.
Instead of doing the hard work of balancing your books, you feel safe ignoring the problem and delaying the solution until “someday.” You’re still only earning $3,000 a month and spending $3,150, but now you also have to pay the $15 credit card bill. Your monthly expenses are now $3,165.
You still only have $3,000 cash to spread around, so this month $165 goes on the card instead of $150.
Like we covered in the last section, you’re paying $12.64 in principal, but you’re also adding $165. In month one your debt was $150, but now you’re in the hole $287.36.
The Problem Compounds
The minimum payment hangs at $15 for a couple months. Then it climbs to $18. Sometime after the first year it crosses $100.
The interest portion is rising as well. Three years in you’ll be paying more than $100 just in interest every night.
Here’s how your payment climbs over time:
Four years in and you’re on the hook for $400 to the credit card company every month.
Not only that, but your total debt has been climbing. Every month your balance has been growing and after four years, you’re over $10,000 in the hole.
Escaping the Trap
We’re going to decide to get you out of this mess now. First of all, we have to see how things wrap up so we can calculate the damage.
Second…I just can’t take it anymore.
There’s only one way out in the long term: Spend less than you earn and pay your debt down with the difference.
So you do what you should have done from the start: You address the root cause of spending more than you earn. You cut your spending so that you are paying for all your expenses (including your credit card) with cash and aren’t adding anything to the balance.
At the peak of your debt, your minimum payment has ballooned to $404 a month. You’re going to keep paying that amount until it’s all gone. Here’s what happens to your balance:
As soon as you stop adding to the balance, you start paying it down. Since the balance is decreasing every month but you keep the payments constant at $404, each payment is comprised of less interest and more principal.
This chart shows your the breakdown of your monthly payment over time:
You started paying things off after four years of accumulating debt. You end up paying off your balance after 82 months, nearly seven years after you first started using the card.
Calculating the Damage
Overall, things aren’t as bad as they could be. You wised up after four years and a balance of just over $10k. Many people rack up debts us multiple tens of thousands.
Here are your final numbers:
|Excess Spending||Total Interest||Total Payments|
Let’s break down where these numbers come from.
We set up this exercise assuming you earned $3,000 a month and spent $3,150 a month. That’s $150 worth of goods and services that you couldn’t afford, but bought anyway for four years.
Four years is 48 months, and $150 * 48 = $7,200
This isn’t stuff that you got for free. It’s stuff you paid for later—with interest.
In any given month, the interest that you owe is (your balance * the interest rate)/12.
That first month your balance was $150, so the math went ($150 * .189)/12 = $2.36.
Of course, you kept spending more than you earned and your balance grew every month. This means your interest payment grew every month. By the time you came to your senses, you were paying $164 in interest.
Once you started paying it off, the amount of interest you paid every month started to shrink.
When you add it all up, you lost $6,474 to interest. In terms of your life energy, you spent more than two full months toiling away at a job just to send money to the credit card company.
This is the most surprising category we’ve looked at. If you we’re over budget by $7,200 and paid $6,474, shouldn’t the total be $13,674—the sum of the two?
The problem is that as time wore on, you relied on the card to pay for a higher percentage of your spending. The first month when you spent $3,150, you were only able to cover $3,000 in cash and the rest was put on credit. The next month, you only had $2,985 in cash to spend (instead of $3,000) because $15 went to pay the credit card.
Each month more cash went to cover the cost of the card, and more and more of your normal spending was financed by credit.
So in total, you ended up needing to pay $22,171.
The Opportunity Cost
In this example, debt trapped you slowly and efficiently. You were able to break free by dramatically reducing your expenses and paying $404 every month without adding to the balance.
The question I want to look at now is what if you had just done that from the start? With no credit card balance, you could have been investing all of that money instead.
Here’s what $404 a month would look like invested for nearly seven years at 7% returns:
Instead of paying out $22,171 and finishing with a net worth of $0 after seven years, you could have had a portfolio of over $40k.
Of course, it gets worse.
When it comes to investing, the earlier you get started, the better. Having a $40k head start makes a huge difference as time goes on.
How much of a difference? Let’s run the numbers.
Here’s how the $40k head start will continue to grow over time:
Not too shabby. This could have been you if you hadn’t gotten into debt. Instead, you spent seven years getting yourself into and out of trouble. Here’s what your portfolio looks like as you start your investments after seven yeras:
If you had started investing early, you’d have a portfolio of $1,035,579. Because you started late, your portfolio is worth $625,013. That’s a difference of $410,566. This was the true cost of borrowing.
It’s Not As Bad As It Could Have Been
Remember, this could have been way worse.
In this example, I had you dramatically come to your senses and make radical changes to start paying off your debt immediately. But you might have just applied for another credit card when you maxed out your balance and continued to dig yourself deeper.
Here are some other factors that could have made things worse:
- A higher interest rate
- Taking longer to pay it off (e.g. sticking with the minimum payment)
- Missing payments
- Late fees
Two Scenarios That Are MUCH Worse
Sticking With the Minimum Payment
What if you got your finances in order, stopped adding to the debt, but instead of paying extra just stuck with the minimum?
Here’s what that would look like:
|Excess Spending||Total Interest||Total Payments||Years to Payoff|
- You still spent $7,200 on stuff you shouldn’t have bought
- The total interest is now more than the cost of the stuff
- Because you needed the card to cover some living expenses as well, in total you paid $25,746
- It took you 18 years to pay off your card
Notice how long the tail is at the end of the graphs. When you pay the minimum, your payment decreases every time you pay down the principal. This feels great, but it lets the credit card company charge you interest over a much longer period.
Paying the Minimum…And the Minimum is 2%
Let’s assume you pay the minimum, but instead of a 4% minimum like we’ve been using, you have a credit card that only requires you to pay 2% of your balance.
This sounds good—who doesn’t like lower payments?—but is actually much worse.
|Excess Spending||Total Interest||Total Payments||Years to Payoff|
Yikes, that’s a super long tail and that second graph has a ton of red.
The key takeaway is that the more you stretch out your payments, the worse interest gets you in the long run. Just pay it off already.
The Bottom Line
The trick with credit cards is that the true costs are very well hidden. When you start down the slippery slope towards crushing debt, it doesn’t look dangerous. It seems like savvy financial maneuvering. Most people who are on the road to bondage probably feel proud of themselves for using such sophisticated financial instruments.
This doesn’t mean that you need to avoid all debt at all costs. It also doesn’t mean you should never use a credit card. But if you do use a credit card you should be very careful. Always pay the full statement balance, make sure the amount in your checking account is bigger than your credit card balance, and never spend more than you earn.