Sunday is personal finances day here at pushing rubber, and today I’m going to talk about something which I’m sure that a lot of you have right now.
Debt is anything that you owe to someone or something else for services or products rendered. It might be a car loan, credit cards, a mortgage, hire-purchase, a personal loan, utility bills that you haven’t been able to pay yet, the list goes on. Interest is the cost of servicing a loan. It is the price you pay for immediate gratification – having something now that you otherwise would not be able to afford.
Most people who are in debt don’t know how much they owe. This is a form of psychological protection. Unfortunately it is also known as living in a world of delusion. It’s almost like hoping that if you ignore it maybe it will just go away. In order to examine the nature of debt I’m going to use credit cards as an example.
Let’s say you have a credit card with a $5000 limit. To the average person when they first receive that card they think they have five grand in their pocket.
“I didn’t have any money before but now I have five thousand bucks! Awesome!”
In reality, not only do you not have $5000, but it’s about to get a lot worse. But before we look at that, here is how you should approach that card.
A credit card has a yearly fee. My card’s fee is around $300. But I have signed up to a card with a major airline so as part of my yearly membership I get 2 flights within Australia. So there is my fee paid for. Let’s say the limit on my card is $10,000. I have set this limit because that is the maximum amount I would use on the card in a given month, (for example if I was on holiday). At the end of each month I have a look at how much I have spent. Last month I spent $3000. On the last day of the month I transferred that amount of money from my regular account to the card. By doing that I pay zero interest. I do this every month. The only cost to me of the card is the annual fee.
The reason I have the card is for airline miles. I receive points for every dollar spent on the card and I use these for flight upgrades. I also use the card for online purchases. These are the two reasons that I have a card. I have never paid interest on the card in the four years that I have had it.
Even though I have $10,000 clear on the card, if I went to a bank for a loan right now they would consider me to be 10 grand in debt because I can use that money at any time. Thus in this sense the card is a liability. But I don’t believe in loans so this is no biggie. The bank regularly asks me if I would like to have more money on my card. I always refuse. They also send me offers for other cards, all ready to go with my name on it. No thanks.
That is how you use use a credit card. Here is how not to use the same card with exactly the same circumstances.
I owe $3000 on the card at the end of the month. I have $4000 in my regular account. So I can pay off the card. But if I do that then I’ll only have $1000 in my account. On an emotional level, this feels bad to me. I went to be a person with $4000 in the bank not $1000. In reality I only have $1000 in the bank. But I can trick myself into believing that I still have $4000 by not paying the card.
This is a very common behavior pattern.
So now I don’t pay off the card. Now I am charged interest. Let’s say the interest rate on the card is 20% which is a very standard rate. The monthly bill will have a minimum payment requirement which in this case will be $61. I pay that money. To keep it simple let’s say that $3000 was my card limit. If I continue to pay the minimum monthly amount it will take me 34 years to pay off the card and I will pay a total amount of $13,254. In other words I will pay over $10,000 in interest on $3000.
I personally know someone who has 5 credit cards which she is using to pay off each others monthly fee.
Debt is a trap. You move from paying off debt to merely servicing debt, which makes you a slave. If you are heavily in debt the only way to break it is to ruthlessly pay it off. Spend nothing on anything else. No going out, no clothes, no having a good time. Just the debt. Even if you only have $100 extra at the end of the month, pay that money. Look at that image and see the difference a monthly payment of $150 makes. That’s $90 more than the minimum and it takes 2 years instead of 34 years.
In Australia there has recently come a new phenomenon that banks offer people to pay off their credit card and switch their debt over to the new back at zero interest which is offered for the first year. This is a great offer, if you use that time to pay off the debt. But the banks know that the vast majority of people won’t do this. What they are doing is stealing their best customers off each other. I am a terrible credit card customer because they don’t make any money off me. They want the good customers with bad debt habits. It’s the habit that you need to break, not the debt itself.
Or just don’t get into debt in the first place. Maybe you’re reading this and you’re still in school. Credit cards aren’t cool, kids. And neither are all the other debt monsters that I mentioned above. But I know what you’re thinking – mortgages must be okay, after all everyone needs to buy a house, right?
The translation from the Latin for the word mortgage is indebted onto death.