Thursday, February 15, 2007

Gong Show #6 - Carrying a Credit Card Balance

This week's gong show isn't a dubious financial product but rather a dubious financial behaviour. The financial behaviour of carrying a balance with a credit card company is sure to cost a lot of money, make the user poorer, make the credit card company shareholders richer, and increase unnecessary consumption.

Paying for things with a credit card isn't bad in itself. It is one of many ways to conduct financial transactions and a very convenient one at that. Using a credit card for necessary purchases and collecting points or getting cash back is actually a very smart financial behaviour provided the user pays the credit card balance in full every single month. This is where most people get into trouble, they don't have the cash to pay the balance in full when their bill arrives. Those stainless steel appliances lose their lustre quickly when you have been paying interest at 17% for two years after you bought them on that shiny new Visa card.

Lets play with that scenario for a moment. Your dishwasher broke, now you need to buy a new one. You have the cash and can afford the $500 for a nice new dishwasher that will work just dandy but your at the store and that set of stainless steel appliances really catches your eye. The salesperson does a great job at persuading you to buy the new set and you are convinced that your life will be 10 times better with these shiny new marvels of modern technology. You plunk down the Visa and $5000 later you walk out of the store convinced you have done the right thing. Remember now that you could only afford to pay $500 but you paid $5000. Its 4 weeks later and now the bill arrives with a balance of $5000 and you only have $500. You wake up at this point and think, "Wow, how am I going to pay this off." then you look over at your appliances and think, "It was worth it. I will pay it off later." and you pay $500.

The fun really starts at this point and this is when the credit card company starts salivating at the prospect of you paying off those appliances for the next 3 - 4 years. If you were diligent and paid $160 per month for 3 years and managed not to buy anything else impulsively you would have paid $1277 in interest plus the $5000 in principal. That sale price on the appliances isn't so attractive now that you have added 25% to the total cost.

The big problem for most people is that they never actually pay off their purchases and they end up 10 years later still paying interest on the appliances they bought and have long since lost the showroom lustre. This is because two years into the plan they broke down and convinced themselves that they deserved a vacation and put that onto their card and two years after that the car's transmission needed replacing and so on and so on. It never ends unless you get real disciplined, buckle down and stop spending. Pay off that credit card balance as soon as possible. Go without things until you do. Reward yourself only after you have fully paid off the card and saved up for a new purchase.

Good old fashioned common sense will go a long way. Refuse to pay interest on consumable items and depreciating assets except as a last resort. You will be the one rewarded in the long run.


John said...

Any concrete numbers on what % of card users carry a balance? What's the average amount of these balance?   I guess these are pretty guarded trade secrets.

I never carry a balance. The only time that I got dinged for interest was when I misread the due date or when I keyed in the balance wrong by a couple of bucks. Expensive lessons learned.

RentingSucks said...

Yup I got dinged too. I swear they do that sort of stuff on purpose especially American Express. This months and last months total are in identical boxes right next to each other. In my first case of dinging I entered the wrong one which was less than the real balance by a couple dollars. Then they charged me interest on the entire amount back to the original date of purchse. I don't use my AE cards any more becasue of it.

I've also noticed that due dates often come on Mondays. This means if you want to pay it early because of the time it takes to post the transaction (got digned by this once too) you have to pay it on Friday 3 days early instead of 1 or 2.

regan said...

Thinking of the long run, if the impulsive stainless steel appliance owner (credit buyer) hadn't been paying that interest for those years, they could have doubled their pleasure by saving the money and making money at the same time.

During the 28 or so months that credit buyer was paying off the extra $4500, that money could have been working for them and making them a total of $900 in that same time at a 8% return compounded monthly.

So the total cost of the appliance upgrade increases to $6700 over and above what they needed. Even if credit buyer 'needed' the nicer $5000 appliance, it has cost them an extra 34% to get it.

Just a thought: If we think that high taxation is bad, using credit when you don't have the cash is like taxing ourselves. If we consummers insist on throwing money away by taxing ourselves, why shouldn't the government think that they are justified in aggresively taxing us too?

mk-kids said...

I hate how the credit companies market to college/ university students! I got suckered and of course after a bunch of years at school & working low paying jobs had a significant balance. I managed to pay it off and will never carry a balance again.

A note to those who have been dinged... this happened to me once & I called my credit card company & they looked at my history and saw the mistake & credited the interest back to me. I'd have probably switched companies if they hadn't.

bc_cele said...

One thing people should also realize is that some credit cards will increase your credit based on if you default on other things (e.g. other CC or loans). In this case, you may start out with a low rate, but your credit rate could jump. Some cards also average your balance so that if you don't pay the balance in full for one month, you could be paying interest for the next two even though you paid the balance in full after that.

Myself, I have only one credit card, and keep it will a low balance because it is for emergencies only. When I do make a purchase, I pay the balance in full. It isn't worth it to get into the credit trap, so I avoid it at all costs.

Warren said...

I'm a responsible credit card user (pay every month), and have a lot of business related expenses that go on a card, so they're great for the points/cash back, but obviously you have to be disciplined. So much of our culture is "buy now, pay later" image focused. The credit card companies are pretty damned sneaky too, here's a personal anecdote:

My girlfriend uses her Visa and pays it off every month as well. She recently had a bill for around $1600 I think. Due to a typo or honest mistake, she underpaid her bill online by like $50 or something. The next bill she receives has a huge interest charge (like $65). Since she was only short $50 she called them up pissed off... well, according to the fine print, unless you pay the entire balance, they charge interested on the entire thing, not just the unpaid amount. She canceled her card on the spot.. watch out, and happy spending. :)