“I’ll loan you $10 today if you agree to pay me back $200 over the next 3 months.”
Let’s face it, nobody would enter that kind of an agreement with a friend. Why is it then that the same rational, forward thinking people agree to those terms with a perfect stranger; in fact a perfect stranger that is a faceless multinational corporation?
One of the largest threats to our own personal growth is the fact that we’ve allowed major credit corporations to invade our lives and get away with daylight robbery. It’s time we put a stop to it right now and the first step to doing that is understanding how it works and how they manage to trick an intelligent person like you.
Let’s first look at the items that I believe are the minimum required to really understand why credit cards are evil. We’ll just look at these questions first. Then we’ll walk through the steps we can use to get the answers to them. When we’re done, I think you’ll agree that this exercise was worthwhile. Somebody is stealing from you every day and you need to stop them right now!
1) What is your APR and how does it compound?
2) Paying only the monthly minimums, how much will you pay back in total and how long will it take?
3) What is an underperforming loan and why is it a bad thing?
If you’re anything like me before I got wise and stopped giving away money for free, these are questions that we all know we should be able to answer but have just never taken the time to look into. Please, I’m asking you not only for the good of your own financial wellbeing but as a friend trying to tell you that someone is stealing from you. Grab a recent credit card statement and play along. It won’t take long and might just open your eyes to how you can keep the money you earn.
Question #1: What is your APR and how does it compound?
Let’s start by finding out about our APR. If you look around on your credit card statement, you will find a section indicating what your Annual Percentage Rate is for this card. It is probably broken out into a couple or more sections: Purchases, Cash Advances, and perhaps another. Check out the “average daily balance” for each category as well as the APR. The APR is the percentage of that balance per year that will be charged to you in interest. Most companies will list out both the APR and the periodic finance charge that they are charging this month as a result.
Let’s calculate the periodic finance charge on a couple of sample statements and see how your current APR can affect the outcome.
Jane owe’s $4080.48 on her HellaGouge VISA card. It is all in “Purchases” which has an APR of 11.40%. Therefore, the finance charge this month is $38.76. Do we just trust HellaGouge corporation, or should we verify this number? Let’s verify:
($4080.48 * 0.114) / 12 = ~$38.76
Excellent! HellaGouge was telling the truth! What we did here was multiply the owed balance by the 11.40% rate (remember that 0.114 is the way to multiply 11.40% as a percentage- shift the decimal point to the left two places). Now from this we learn that Jane is going to pay about $40 in interest this month. What happens if Jane misses a payment and her rate is increased to 29.95%?
($4080.48 * 0.2995) / 12 = ~$101.84
Holy cow Batman! That means Jane is paying almost three times as much in interest just because her APR changed. Worse, she’s paying almost $100 just in interest. That is why knowing your APR is important. But please, bear with me…we’ve only just started!
What the heck is compounding?
From the calculation above, can we then just imply that if Jane is paying $100 per month in interest on her card that she would be paying $100 x 12 = $1,200 per year in interest? That seems like a lot of interest to be paying. Well, the truth is that Jane is actually paying even more than that in interest per year because of a little trick called compounding. There is a kind of financial sleight of hand that is being played in a heavily premedidated way to ensure that even this loan can gouge Jane for every last little dollar that she earns. Compounding is the effect of taking the interest owed on a principal (the balance to you and me) and adding the two numbers together to get the new principal. How often this is done is the compound schedule. Monthly compounding means that interest is added on to the principal monthly, whereas quarterly compounding means that interest is added on to the principal every quarter, i.e. four times per year. Financial institutions are required to inform their customers which compounding schedule their loan is on. If you do not have this information, call the number on the back of your card and ask customer service. It is very important that you fully understand the rules concerning the money you have borrowed.
Question #2: Paying only the minimums, how much will you pay, and how long will it take?
If I was loaning you some money, say $20, you’d probably ask me “When do you want me to pay you back?” If we’d talked about interest, you’d want to know how much I was going to charge you and when. Because I’m a friend, someone you trust, you want to know absolutely everything about our agreement and how much you will owe me. However, if I was a faceless corporation offering you $2,000 then you wouldn’t want any of that information, right? You wouldn’t want to know how long or when, or what the total interest payments would be. Let’s change that. Let’s figure out exactly how much Jane is going to pay and exactly how long it will take. I know that lingering in your mind is that doubt about whether you even really want to know the answers to these questions. I’ve been there. Trust me though. The only way to start fixing this is to know your enemy and understand just how much money these accounts are taking away from you every month; money that you could have in your pocket.
I’m going to throw out a math formula now, not because I’m a cruel person but because it is a tool just like a screwdriver that you can use to solve a problem. Ignore the fact that it has a lot of symbols and instead start up the Windows Calculator (Click Start then Run… then type Calc and click OK). We know that Jane owes $4080.48 and has an interest rate of 29.95%. Now we’re going to figure out how that balance will compound over a few years. Here’s the screwdriver that will let us do it.
A = P (1 + (r/n))^nt
Breathe! It’s just a formula. The ^ symbol means “to the power of” and the rest should be pretty familiar.
P = principal amount
r = annual interest rate
n = number of times per year the interest compounds
t = number of years
A = amount after time t
We’re going to do this together and I want you to click along on the calculator to get comfortable with using this formula. First, click View->Scientific from the pull-down menu at the top of the calculator window. You’ll need that to do the ^ (power-of) part of the calculation (it’s a little x^y button). Try to play with this calculation until you can get the numbers to come out the same. It’s important that you know how to use this screwdriver and it should only take a few minutes. Earning thousands of dollars in a few minutes sounds pretty good, right? That’s what knowing how to use this screwdriver could turn into.
Sooo if we calculate for 5 years:
P = 4080.48 (balance)
r = 0.2995 (apr)
n = compound 4 times per year
t = for 5 years
A = 4080.48(1 + (0.2995 / 4))^(4*5)
A = 4080.48(1 + 0.074875)^20
A = 4080.48(1.074875)^20
A = $17,293.01 after 5 years.
Wait a minute. That can’t be right? Jane’s balance (if not paid off) will rise to $17,293.01 after just 5 years! That seems like we made a math error, but the sad truth is that we did not. We found earlier that Jane’s minimum payment per month is only slightly above the interest that is being charged each month. That means that Jane is only really covering the interest that is being charged each month and never really touching the balance.
The slimeball revealed: the dirtiest trick of them all!
Dirty Trick #1: Your balance is not your balance
It gets worse! There are two really dirty tricks at work here, so much so in fact that I still get sick to my stomach when I think about them. If Jane’s balance kept on going up and up towards $17,000 then alarm bells would start to sound in her head and she’d pay enough attention to the situation to want to fix it. However, because the “minimum payment” just about covers the interest (in fact even taking a very small amount off each month) Jane is able to convince herself that she is paying off the debt. Furthermore, she reminds herself that all she owes is $4,000 and that she is paying if off over a few years. This perception is very wrong. Take a second to think about it. She is not paying four thousand dollars off over five years. She is paying seventeen thousand dollars off over five years, and pretending not to have wasted twelve thousand dollars because the monthly total on her statement stays roughly the same. This is one of the most cruel financial sleight of hand tricks anyone can ever play on you. It is wrong and it is happening to thousands of people every single day.
Dirty Trick #2: Your balance never changes
As if all of this wasn’t bad enough, HellaGouge have figured out a way to close that last little gap in the perfect daylight robbery. They have figured out that because Jane is paying $112 (her minimum payment) and only $102 is being put back on in interest each month, she is actually reducing what she owes them by $10 per month! HellaGouge will not stand for this! Given (4000 / 10 = 400 months = 33 years) thirty three years Jane could actually be free of the debt. She might live longer than that and HellaGouge want their money so each Christmas they send her a letter indicating that they understand that Christmas is expensive, offering that she should “skip” a payment this month to ease an already squeezed December. However, they still charge interest on the account, funnily enough they charge the typical $102 that they charge every month. Jane managed to pay off $120 that year, remember that she’s paying $10 per month, and now HellaGouge just set her back $102. That means that Jane only actually paid $18 of the $4000 she owes this year. Ever wonder why your credit cards never quite seem to get paid off despite the fact you’re sending $100 per month to them? This is why. They are literally taking everything you have, right from under your nose.
Question #3: What is an underperforming loan and why is it a bad thing?
Loans are intended as a way for people to get the money they need to start making more money and get themselves on their feet. The whole purpose of a loan is to get you started so that eventually you can make your own money without the need for loans. It doesn’t really sound like Jane’s credit card is helping her out in this way at all. In this way it is considered to be underperforming. A performing loan is, as it’s name suggests, one that performs a function for you, specifically the function of making you more financially independent. If a loan isn’t actively working to make you more money then it is not performing. Educational debts are an example of performing loans. Each day that your degree earns you a higher salary, the student loan that got you there is performing for you; the money is being put to good use.
Take a moment to think about the dollars that are on a credit card, where they came from, and what those items and purchases are doing for you right now. Some are in recreation, some in household items, some are forgotten expenses, and hopefully a few are towards expenses that are actively helping you to get ahead. The sad truth is that almost all credit card balances carry 100% underperforming debt. The money is doing absolutely nothing to get you ahead whatsoever and is simply a burden on all of the hard work you are doing. That is the essence of loan performance and is why underperforming debt must be done away with as quickly as possible.
I’m going to continue to write articles on this topic, bringing forth the murky and undiscovered atrocities that are occurring every single day in the bills on your kitchen counter as well as try to provide strategies to get out of this situation and start paying yourself instead of credit corporations. I hope that in raising some awareness with real examples that you can perform yourself in the Windows Calculator that we can start getting more money in people’s pockets and stop bleeding it away to the slavers of our modern world. Stop working for them now. You wouldn’t do it for me; don’t do it for them.