Paying Interest on Debt
Imagine going to a gas staton and asking the attendant if you can have $20 of gas on pump 3. Oh, and by the way, does he mind if you pay him later? Impossible right? In today’s world, there aren’t any IOUs, or running up a tab in the local grocery store. Things have to be paid up-front and in full. This is difficult for many people who live paycheck-to-paycheck, and also for those who buy what they want, when they want. What happens when we want something we do not have money in the bank for? Or, even worse, what happens when we need something we do not have the money for?
Recently, I was talking with someone very close to me who is in a bit of a financial pinch. He has made some wrong turns and is looking at about $8,000 in credit card debt. He was very nonchalant about this amount, and emphasized over time, he could knock out that $8,000. I realized he did not understand the credit card interest was eating away any minimum payment he might be able to send toward the balance. This is why I am writing about something as seemingly simple as interest.
Interest Isn’t All That Simple
Credit cards, staggered due dates, payment plans, and other financial hokey pokey all make spending money seamless. Why might this be problematic? It makes it very easy to spend more money than we earn, every month, and not even know it!
What’s the big deal? If everything gets paid at some point, and I am still bringing in money every month, what’s the problem? The problem is, it is expensive to spend more than I earn every month. Not just because I am spending all of my money, but because I am likely paying interest on some of my spending.
Fascinating Example of Interest: Credit Card Debt
Back to the example of my friend who owes $8,000 in credit card debt. Say his annual interest rate is 17%, and he pays the minimum payment every month of $25. Using calculator.net, I plugged in these numbers to see a bone-chilling result: “It is unlikely that you can pay off the balance with a monthly payment of $25”. Wait, what? He will pay that forever? Not exactly, but it’s still pretty grim.
Here’s why: every month the remaining balance is “taxed” with interest. Initially, he charged things on his credit card when he did not have the money. In return for “loaning” him the money, the credit card company will charge him interest if he does not pay off the balance in full by the end of the billing cycle. If his interest rate is high, and his payment amount isn’t high enough, he may end up not paying down much of the debt at all.
Credit Card Interest Broken Down
Credit card companies use an annual percentage rate (APR), but assign billing cycles and due dates using a monthly time frame. To complicate matters, when he reaches the end of his billing cycle while carrying a balance, the interest accrues daily. So we’ve got months, days, and years all jumbled into a formula that spits out an extra amount to be tacked onto the initial balance. Translation: It is not as simple as 17% on the entire balance (in our example, 17% of $8,000).
So How Do We Translate an Interest Rate to Real Dollars Owed?
A simplified version: Divide your APR by the number of days in the year. Multiply this number (your daily rate) by the balance you are carrying at the end of the billing cycle. Then, multiply this number by 30 (the number of days in your billing cycle).
When his billing cycle ends and his payment is due, the 17% APR will be broken down to a daily rate. This daily rate will then be multiplied by the balance owed ($8,000), and again multiplied by the number of days in the billing cycle. Result: The amount of interest added that month. In this case, his owed amount shoots up to $8,111.78. If he makes a $25 payment that month, great—it will bring his balance due down to $8,086.78. Notice this amount is more than he started with, even after he made a payment.
Then he chugs through the next month, not using his credit card, and therefore not adding to the debt. The month is over, the billing cycle ends, and his credit card payment is due again. Interest is charged on the balance due (which is now $8,086.78). Using the formula above, he now owes $8,199.77! He will have to pay much more than $25 a month if he wants to ever be free from this debt.
Another calculator showed that paying $25 a month would allow for the credit card debt to be paid off in 33.8 years. Over the life of the debt, the total amount paid would be $17,332.58, or $8,000 in principle and $9,332.58 in interest. That’s a pretty hefty charge from the credit card company for this “loan”.
Editor’s note: The formula to calculate interest on a credit card is likely more complicated depending on your credit card company. Your credit card company might take your average daily balance for the billing cycle, rather than your end of cycle balance. Or the interest rate might negatively compound each day beyond the end of your billing cycle, rather than negatively compounding monthly. The interest could also be higher if you have a variable APR (instead of a fixed APR) and your bill is past due.
Bottom line: Don’t carry a balance so you won’t have to pay interest at all!
Fascinating Interest Example: Car Loan Debt
Credit card interest isn’t the only way we can pay more than the actual value for an item. What if I need a car to get to work so I can make some money? I am not going to go into detail the merits of buying used vs. new at this point. Let’s just say I get a used car, a couple of years old, for about $17,000, with $2000 down, and 5% interest (in 2015 I actually did this very thing). Using calculator.net I can plug in the numbers to see how much interest I will pay over the life of the loan.
Whatever the interest is, its worth it, right? I need to be able to get to work. With no car, I am seriously jeopardizing any shot at bringing home any money. So I sign the papers, and am happy to pay whatever in the future, so I can have this car today. In my mind, this loan puts me at an advantage.
Car Loan Interest Broken Down
Perhaps it’s (arguably) advantageous to have a car loan, if it means getting a car. However, I might not realize for a loan spread over 5 years, I will pay over $2000 in interest alone. Now, compared to the price of the car at $17,000, this 4 digit interest payment feels like pennies. But it’s not! It’s a decent chunk of change no longer available to put toward my savings, emergency fund, investments, retirement, vacation, living expenses, etc. Now the $17,000 car becomes almost $20,000!
This is not to say, never get a car note. I did, and I paid it off as quick as I could, well before the 5-year payoff date. Driving all around town as a free-lancer, I am in the car at least 25% of my day, and I am happy with my car. If my car was totaled tomorrow, and I needed to make this decision all over again, would I? For me, probably not. Knowing now, what I did not know back in 2015, I would probably look for a quality, used car and pay cash up-front.
What’s My Point?
Pay our credit cards off in full, avoid paying interest and spend less than we earn! A fool-proof way to avoid paying hundreds of dollars in interest (or tens of thousands over a life time) is to save money and pay for things in full. The problem with paying cash up-front for anything, whether it be a new car, a new TV, a tank of gas, that month’s groceries, whatever… I have to have cash! I can’t pay anything up-front and in full without cash on-hand. If I don’t have it, I just might put something on a credit card without having a plan for how I will pay the bill ASAP to avoid interest. Or at the dealership I might sign a stack of papers with tedious language I don’t understand, and be indebted to someone for 5 years.
When I am able to not spend all my money, and especially not spend more money than I earn each month, I am able to set aside some “power” money to be used at a later date. “Power” money is exactly what it sounds like. It’s money on stand-by that gives me power. With “power” money I can pay for my groceries in full; I can even pay for a car in cash if I was diligent and saved. Who calls the shots? Me! Who decides how much I am going to pay for something? Me! I can make well-thought-out decisions that allow me to not overpay for an item via interest.
Are Credit Cards Really That Awful?
I admit, I do almost all of my spending on credit cards. I have a few credit cards open that provide really top-notch rewards programs. However, once I got myself out of debt, I did not start using credit cards again until I was certain I could pay them off every single month. It was crucial to avoid any interest, and not pay the bank and the store for an item I purchased. Initially, it was challenging to send way more than the minimum payment to my debt every month. But, with a little persistence, and some budgeting, it happened. I have never heard anyone say they regret getting themselves out of debt. And anyway, who doesn’t like a challenge?