Remember that monster that lived under the bed when we were little? If we got out of bed he was certain to latch onto our legs and yank us under. Where we’d be tortured, or eaten, or worse.
What we didn’t know was we’d still have to deal with the monster as adults. He has a day job as compound interest.
He seems harmless enough, on the surface. If we have a savings account, own mutual funds, or buy stocks that pay dividends that we reinvest, compound interest is actually a good friend. Especially when we keep money in the account a long time.
But if we use credit cards and are financially illiterate, the monster can grab us by the throat—or the balls if we’re of the male persuasion—and torture us, or worse.
We’re citizens of a democracy and consumers in a mixed capitalist economy. Citizenship has responsibilities: voting, paying taxes, understanding our Constitutional rights. And not just the right that inexplicably leads to fantasies of high-powered assault rifles. Consumers who use credit cards that charge interest on an unpaid balance have responsibilities, too. We can’t just fly on the fantasy that a closetful of designer shoes is ours with MasterCard. Banks profit hugely when we don’t pay off the balance each month.
There are consequences to carrying assault rifles. We can’t expect a dude whose skull contains nothing but a brainstem to weigh the effects of shooting a high-powered weapon. Without firearms training (and a brain), someone could get hurt.
By the same token, we need to know the consequences of using MasterCard and Visa. And to understand that the compound interest we wrack up can lead to financial ruin. If we’re not financially literate,* we’re like the dude with the empty skull. And the someone who could get hurt is us.
If we lack financial literacy two things can happen:
1) We employ the assault rifle—or any firearm for that matter—to steal designer shoes and whatever other consumer products we fancy. Then we say fuck the credit cards, except the ones we steal using our firearm; those we sell on the black market. You can quickly see the downside of this situation, especially if you lack black market connections. Sad to say, this is actually the more positive scenario.
2) We end up with 9 maxed-out credit cards. And swear a debt-burdened life is a small price to pay for a closet filled with designer shoes. And dresses and bags. Or suits and man purses. We know that credit card companies charge interest on any unpaid balance. What we’ve failed to learn: If we don’t pay at least the accumulated interest each month, Bank of America or First National of Sioux City will take that interest and compound it daily. Till death do us part. Or we pay off the balance. Whichever comes first.
Like all financial illiterates, we figure what paying off the cards will end up costing us: the total of the amounts due, plus the straight interest—at 13 or whatever percent—on that amount. If we hold 3 cards and owe $26K, we add 13% and get $29,900.
But that’s not how it works. The banks that issue the cards charge compound interest, which means we’re paying interest on interest. Say we have 3 cards and the amounts we owe are $8K, $6K, and $12K, all at 13%. And we only pay the minimum balance due each month.
Here’s why the monster’s licking his chops: Using the Federal Reserve’s Credit Card Repayment Calculator, even if we don’t charge another cent on these cards, it’ll take between 22 and 29 years to pay off the debt, depending on the card. And we’ll end up paying $28,528 in interest alone. (The amount of interest is higher or lower depending on the interest rate.) That’s more than the $26K we currently owe. Which is considerably more than the cost of all the items we’ve charged. Fuck you, compound interest.
Of course if we pay more money each month, depending on how much more, we can dramatically reduce the length of payback time and the amount of interest due. The bank holding the card will probably start whimpering. People in debt make bankers fat and happy. Ever see an illustration of a banker with a waistline and a frown?
*Financial literacy is understanding: the basics of saving, investing, and planning; credit and compound interest; types of available loans.