04 - Debt & Credit Cards, Financial Crack

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“You want the truth, you can’t handle the truth.”                                                                        Homer Simpson

All You Need To Know

Credit card companies charge the highest rates this side of pawn shops and loan sharks.  You will not incur credit card debt as this leads to poverty.  If you have some, your immediate goal and most important goal is to pay it off because the real cost of credit card debt is north of 30%.

Carry one card for emergencies (emergencies are defined here as having money to call the hospital when your arm is cut off, not the ability to buy a pair of shoes) and throw the rest in a drawer.  Do not cancel the cards.

The Details

I hate credit cards.  I hate FICO scores.  I have both. 

Credit cards come in handy but only in emergencies but people differ in defining emergencies so let’s go through some basic rules and basic financial theory on debt overall. 

Rule Number 1-There is no good debt.  There is only varying degrees of bad debt; not so bad, bad but could be worse, and worst.  The interest rate varies accordingly.

Not So Bad Debt is made up primarily of mortgages and student loans.  Interestingly enough they carry the lowest interest rate because mortgages are secured by the house and student loans are guaranteed by the Federal government or more correctly, you the taxpayer.  Secured means the lender gets the house and the downpayment if the borrower doesn’t pay.  Guaranteed means that the lender’s credit risk is not the borrower, in this case a new graduate who is a terrible credit risk, but the government because the government, in an attempt to make college affordable, guarantees to pay if the student defaults.  Because the risk to the lender in both cases is low, the interest rate charged is the lowest.  Finance is easy.

Could be worse debt is stuff like car loans and loans made to buy things like washing machines, home entertainment centers, and other stuff.  The loans are secured by the stuff but you might run the car into a lightpole or not change the oil and the thing wears out so the interest rate charged by the lender is higher than the rate charged on houses and student loans.  This leads to Rule Number 2-The higher the risk, the higher the reward required by the lender.

Which segues into the Worse debt which is credit card debt.  Credit card debt is unsecured debt-Citibank cannot repossess your lunch and doesn’t want to.  The only thing backing the card is you and a lot of us are bad credits so Citibank and the thousands of other lenders that send you cards in the mail have to make up the lack of security and bad borrowers through-all together class-higher interest rates.  In fact, the highest outside of a pawn shop or loan shark.  But this is not the place for a tirade against banks for forcing credit cards on us.  A lot of useful things are dangerous if not used wisely---like fire.  If people are stupid enough to pay 15-20% over inflation and pay only the ‘minimal amount’ each month, so be it. 

Which leads to Rule Number 3-You will never pay off the balance paying the minimal amount each month.   Rule number 3 comes into play because most finance books and finance columnists say that it takes 10 years and three months to pay off a $10,000 balance if you make only the minimal, required payment.  Actually the time period is forever because if you get the balance down you will just add to it and the balance goes back up. 

So what’s a girl to do?  Hopefully, nothing because hopefully you have little, if any, credit card debt.  If you have any, pay it off.  Many planners say to pay it off because if you are paying, say, 20% on the card, that is an immediate 20% return when paid off.  I think this is way too low and here is why.  This is Rule Number 4-If you are borrowing, you are not investing.  There are some exceptions but for the time being, buy off on this because of this formula:  Credit Card Interest plus Forgone Investment Return=True Cost of Credit Card Debt.  In this example, you are paying an interest rate of 20% (low by historical standards) and forgoing the seventy-five year average annual return of the stock market of 11% SO the real rate of return that you are NOT getting is 31% (Credit Card Interest Rate of 20% plus Foregone Investment Rate of 11%=31%.) 

The real cost of credit card debt is 31% and we need to get rid of it and the only way to do it is to pay it off.  Quit using it and start paying it off.  That’s it. 

But how?  I hate credit card debt so much I even hate to go here but I will.  Here goes.