If you’re paying the interest on the interest, you will rapidly get into trouble with debt.
The most important concept to know when it comes to credit is the principle of compound interest.
Here’s an example: If I give you a penny and say that I’m going to double the money every day for a month, any guesses how much you’d have at the end of the month? Five dollars? Fifty dollars?
It would be $10.7 million.
What happens is a penny becomes two pennies, and that becomes four pennies, then the buck becomes two bucks, and so on. It adds up. And this is the principle--slightly exaggerated--of compound interest. Your interest is earning interest as it grows.
This principal works for you when you’re putting money aside in your 401(k) and your returns are earning returns.
But if you’re paying the interest, instead of getting the interest, that’s how you get into trouble with credit.
Say you go out for a nice dinner and put the $50 charge on your credit card. When the bill arrives next month, you pay the minimum payment. Let’s say it’s 2%, or about $1. If you only make that $1 payment each month, it will take you 82 months to pay off that dinner. Now I don’t know about you, but I can barely remember what I had to eat last night. Seven years from now, I’m not going to know, I’m not going to care--and yet I’d be paying for that dinner over that whole time.
Now that’s if you continue to pay that $1. The minimum payment, if you don’t add anything else to your credit card, is going to go down. So if you only paid the minimum payment, it would take you many years more to pay off a $50 dinner.
The average American family has more than $5,000 on their credit cards. At 15% to 16%, they’re paying between $800 and $900 a year in interest. If you invested that $800 or $900 a year instead and got an 8% return, you would have $100,000 or more after 30 years.
The point is that if you’re investing in yourself, you’re going to have a heck of a lot more to show for it than if you’re giving it to First USA or Providian or Bank of America or Wells Fargo.
Still, credit is important in our society. These days, your credit report determines not only whether you can get a loan but also how much it will cost. A credit report can determine whether you can get a certain job, a security clearance, an apartment. It’s hard to do without it.
Lenders evaluate your credit report using something called a credit score, which is a relatively new phenomenon. Credit scoring basically translates your credit report into a number. The most commonly used credit-scoring method was created by a company called Fair, Isaac & Co., and the method is know as a FICO score.
What determines your credit score? It’s a trade secret. But lenders and even Fair Isaac itself have given us some indications of what helps and what hurts. Paying your bills on time and not maxing out your cards are both important.
If you want to be smart about credit, pay off your consumer debt--credit cards, car loans, personal loans. You have other goals in your life: You have to invest for retirement and save money for an emergency fund so that if you lose your job you’re not out on the street. But put a high priority on paying off that consumer debt; it will really help you get ahead.
If you’re trying to figure out what to pay first, list your debts on a sheet of paper along with the interest rates, and pay the highest-rate card first. Then take the same monthly payment, whatever you’ve decided you can carve out of your budget, and apply it to the next-highest-rate card. Continue paying minimums on the rest. There are some great debt reduction planners on the Internet; try Quicken’s at http://www.quicken.com.
If you are a person who needs immediate results, you can start by paying off the smallest balance first, so you have something to show yourself that you can do it. Then go back to the highest-rate debt and start paying that.
Otherwise, be a bold consumer. Ask your credit card company to lower your rate or waive your annual fee. If you’ve got good credit, chances are they will.
Look at every statement. Incorrect charges can get slipped in, and your credit card company can change your interest rate, add new fees, shorten your grace period, charge you sneaky fees. If you keep using the card and don’t object, then you’ve given tacit approval that you accept the charges and fees. You really have to pay attention.
Compound Interest Simulator
This applet will allow you to investigate savings account earnings, credit card debt, and a stock market simulation.