Did you learn how to use a credit card in school? Most likely not. Well, neither did I. If I had, then maybe I wouldn’t have used my first credit card like a free shopping spree at Macy’s. No one taught me about compounding interest, making payments, late fees, or how big of a hole I could dig myself into if I kept buying stuff on credit. In this modern age, understanding credit cards, and the do’s and don’ts is one of the most important things to learn about in order to stay out of debt. Not to mention, staying out of debt is one of the aspects of getting to financial independence, and is vital in the midst of any financial crisis.
See: How Do I Survive the Recession for great information on staying out of debt, and best practices during a financial crisis.
If you’re already in debt, there’s a lot of information out there to get out of it. One such way is the Snowball Method. Basically, you start with our smallest debt, and pay it off. Then you move on to the next smallest and pay that one off. And you keep working your way up until you’re paying off your biggest debt. You can use this Debt Snowball Debt Calculator from Dave Ramsey that can help you start it off.
Below is a great example of how using credit cards can turn something that sounds simple into a difficult situation. Maybe you know someone that needs this. This would also be great for kids so they understand it before they’re ever caught in a mess of credit card debt. So share this with someone! You might end up saving them from themselves!
The Situation – What if I don’t have the money now?
Lets say your kid wants an Xbox that costs $500, but you don’t have the money now. It’s Christmas, and you really want to come through, and be the cool parent (not always the best choice.) You’re at one of the big box stores, and you see an advertisement for a credit card at the register. You go through the process and they pre-approve you for.. Wait for it.. Five hundred big ones! Score! Needless to say, you walk out of the store with an Xbox in hand, and a cute little monthly bill.
Now, you didn’t really read the fine print, but for learning purposes, I’ll explain some of it here. You bought this in mid-December, so your first bill won’t come until mid-January; and believe me, it will come. One thing you didn’t notice was that the credit card will actually charge you a 24% interest rate annually on what you owe and add it to your bill. This is why understanding credit cards and what is actually happening when you use it to pay for something is so important.
Paying off a credit card? Don’t forget interest!
Interest is the price you pay to borrow money or the cost you charge to lend money – Bankrate.com
Finally, January is here, and you receive your credit card bill. You see that the minimum payment required is $25. You think to yourself, “This ain’t too bad!” Now, let’s go month by month for the first year, getting by on just paying the minimum amount. You’ll notice that the addition of that interest charge can add up pretty quickly.
*note- interest is calculated for one year, so for one month’s payment, we divide by 12. So 24% divided by 12 would be 2%
January
Interest: $0.00 (grace period on 1st month)
Owe: $500
Total: (Owed + Interest)
Paid: $25
Remaining Balance: $475 ($500 – $25)
*I’ll elaborate the first month where interest is charged so you understand the math.
February
Interest: $9.50 = 2% of $475
Owe: $484.50 = $475 plus $9.50
Paid: $25
Remaining Balance: $459.50
March
Interest: $9.19
Owe: $468.69
Paid: $25
Remaining Balance: $443.69
April
Interest: $8.87
Owe: $452.56
Paid: $25
Remaining Balance: $427.56
May
Interest: $8.55
Owe: $436.11
Paid: $25
Remaining Balance: $411.11
June
Interest: $8.22
Owe: $419.33
Paid: $25
Remaining Balance: $394.33
July
Interest: $7.89
Owe: $402.22
Paid: $25
Remaining Balance: $377.22
August
Interest: $7.54
Owe: $384.76
Paid: $25
Remaining Balance: $359.76
September
Interest: $7.20
Owe: $366.96
Paid: $25
Remaining Balance: $341.96
October
Interest: $6.84
Owe: $348.80
Paid: $25
Remaining Balance: $323.80
November
Interest: $6.48
Owe: $330.28
Paid: $25
Remaining Balance: $305.28
December
Interest: $6.11
Owe: $311.39
Paid: $25
Remaining Balance: $286.39
Financial Checkpoint.
Ok let’s stop here and see what we have. From $500, we’re down to $286.39, so we brought down the balance by $213.61 ($500-$286.39)
BUT! We also paid Interest each month. If you add up each interest payment, you get $86.39. That means that our $500 Xbox now costs $586.39, and we’re not even done paying it! Understanding credit cards also means making sure you understand the math so you can stay on top of what you owe. Still, the idea is to not use credit cards to buy things you can’t afford, but once you’ve already done so, make sure you do everything you can to understand what you’ve actually gotten yourself into.
What if I can’t pay my credit card bills?
That was year one. Let’s move on to year two, but this time let’s add a bit of reality to it. Because life will inevitably throw us some curve balls.
Year 2:
January
Interest: $5.73
Owe: $292.12
Paid: $25
Remaining Balance: $267.12
As mentioned above, here’s that curveball I mentioned earlier: Your car’s engine finally gives out, and you have to dish out $3,000 to the cheapest mechanic you could find. The mechanic will only take cash, so you pull together the $1,500 you saved up for your vacation to Puerto Rico and hand it over. Luckily, he’s a friend of the family, and agrees to let you pay him the next $1,500 over the next 3 months. So now you have to come up with $500 extra per month until April. This requires you to put some things on hold for a while. For one, your vacation, happy hour on Fridays, takeout, Netflix, maybe some other things you spend money on regularly, and last but not least, your monthly credit card payments. You figure, why not? They can wait a while, right?
*note- Your due date is before your statement date (when you receive your bill,) so once the credit card company doesn’t receive your payment by that due day, they will include a late fee in your statement. Another key point about understanding credit cards means you have to learn about any fees, or hidden fees that can be incurred in certain situations. That can include late payments, annual fees, over limit fees, cash advance fees, etc.
February
Interest: $5.34
Late Fee: $15
Owe: $287.46 ($267.12 + $5.34 + $15)
Paid: $0
Remaining Balance: $287.46
March
Interest: $5.74
Late Fee: $15
Owe: $308.21
Paid: $0
Remaining Balance: $308.21
April
Interest: $6.16
Late Fee: $15
Owe: $329.37
Paid: $0
Remaining Balance: $329.37
Back on Track? Maybe not
You’re finally in the clear and pay off the mechanic. Yayy! But these past few months have been stressful trying to make ends meet and have extra money for the mechanic. You completely forget to set up the automatic payments for the credit card for another 2 months.
May
Interest: $6.59
Late Fee: $15
Owe: $350.96
Paid: $0
Remaining Balance: $350.96
June
Interest: $7.02
Late Fee: $15
Owe: $372.98
Paid: $0
Remaining Balance: $372.98
You realize that you haven’t paid, and finally turn it back on.
July
Interest: $7.46
Owe: $380.44
Paid: $25
Remaining Balance: $355.44
August
Interest: $7.11
Owe: $362.55
Paid: $25
Remaining Balance: $337.55
September
Interest: $6.75
Owe: $344.30
Paid: $25
Remaining Balance: $319.30
October
Interest: $6.39
Owe: $325.69
Paid: $25
Remaining Balance: $300.69
November
Interest: $6.01
Owe: $306.70
Paid: $25
Remaining Balance: $281.70
December
Interest: $5.63
Owe: $287.33
Paid: $25
Remaining Balance: $262.33
Should I keep paying the minimum balance?
So now you owe about $262 on the Xbox purchase! But wait. Didn’t you just owe about $286 a year ago? So for the whole second year you only paid off $24? That can’t be right! You feel like you paid off way more than that! So, let’s put this into perspective, because when understanding credit cards, and understanding where your money, is what’s going to help you avoid a lot of headaches. You’ve actually put out $475 of your hard-earned money already in the past two years. And you have nearly another $262 to go, and that’s not including interest you’ll pay if you keep paying month to month. The best advice here is, if you have the $262, just pay it off completely and save yourself from having to keep paying that interest.
If you keep paying the minimum of $25, after 13 months, and another $300.14 later, you’ll finally pay it off! With the $475 you already paid, that’s a total of $777.14; But wait! Wasn’t the Xbox only $500? That’s the cost of using credit cards unfortunately.
The ugly truth of using credit cards
Now, this story has been simplified for learning purposes only, because understanding credit cards could get much more complicated than this. I didn’t include that after some time of not paying, you’ll get bill collectors calling you and that they could actually increase the late fees. They could also raise the minimum payment. In a nutshell, you could, and would most likely owe more in real life, and it would be a major headache!
The sad truth is that most people don’t just stop at buying only one item. They’ll buy many more things if they have a higher limit, and sometimes use multiple credit cards. Certainly, this can make it extremely difficult to get out of debt, especially if you’re trying to pay other things, like student loans, or a mortgage, or your care. The ugly truth is that this is the perfect way to create your very own financial Hell.
If you can’t afford it, don’t buy it!
Look I’m not saying credit cards are all bad. There is a proper way to use them, and I will actually go over that in a later post. However, more often than not, this is how they’re used, and is a reason so many people are living paycheck to paycheck. This whole post’s goal is to help you understand credit cards, which is a great step towards getting on a path to financial freedom, because you don’t want to be a slave to credit card companies.
All in all, to stay financially healthy might mean you have to sacrifice a certain lifestyle and give up things that don’t really serve you too well. However, having things, even expensive things, is NOT a bad thing. Unless you can’t afford them. Basically, the moral of the story is – if you want to buy an Xbox, just save up the money and buy it when you can afford it! And if you can’t afford it without a credit card. DON’T BUY IT!
Again, if you’re already in a tough spot, the Debt Snowball Is a great way to start getting out of debt. Use this link to figure out how to start getting out of debt: Debt Snowball Calculator
