Why is credit card debt bad?
Any good financial coach, planner, or advisor will tell you to pay off your credit card debt as soon as possible. Further, they will politely suggest that you not get into credit card debt again. It’s easy to take this advice for granted as truth, however, I’d like to quickly explain WHY you should get out of credit card debt or not get in it in the first place.
It is perfectly acceptable to borrow money to invest in your education or your home. Your home will appreciate at about 4-5% per year. Your education should allow you to earn more income than you would have without it. Borrowing money in general is not a bad thing, but credit cards are not used to buy a house nor pay for school. We use mortgages and student loans for these investments. Credit cards are almost always used for depreciating assets, meaning if you buy a sofa for $2500, by the time you pay the credit card balance off, it will be worth much less. Your house and your degree will be worth more.
Compound interest is the best thing in the world if you’re the one earning it. The concept goes like this: you invested $100 last year and earned 5% interest, so now you have $105. Next year, that $105 will also earn about 5% interest, and then you’ll have $110.25, and so on. Your interest becomes your employee, to borrow from Rich Dad Poor Dad, and starts earning money for you. This is an example of annual compound interest. Now imagine it’s not your investment balance that is growing. Imagine it’s your debt. And imagine the interest is 18%. Now, imagine that instead of compounding every year it’s compounding every day. It can take a very long time to pay off a credit card. If you’d like to calculate how long it will take to pay a credit card balance, real or imaginary, Info For Investors has a good calculator here.
Lower Credit Score
We’ve written quite a bit on credit scores, so let’s not spend too much time here. Just know that a portion of your credit score (30%) is calculated based on how much debt you are using versus how much you have available. High credit card debt means a higher utilization rate and a lower credit score.
Minimum Payments Are Deceptive
People who borrow using credit cards can get lulled into a false sense of financial security because the minimum payments can be very low compared to the balance of the loan. It’s easier to say no to a new $2,000 house payment or $500 car payment. It’s not as easy to feel the damage a purchase can make if the credit card’s minimum payment is $25 per month. These minimums encourage more purchases, and therefore more debt, fees, and interest.
Borrowers Spend Money They Don’t Have
The biggest problem I personally see with credit cards is that people purchase items with money they don’t have. They then use the item in the short term but continue paying for the item long after they wanted or needed it. This behavior can lead to a cycle where consumers are paying for their past purchases with their present earnings. Financially, it’s much better to save and invest present earnings for future purchases (see the positive compound interest example above).
These are only some of the reasons to stay away from credit card debt. Borrowers use money they don’t have to pay for things they may not even need. They then pay high interest and get tricked by deceptive minimum payments, all the while driving up their utilization and most likely lowering their credit score.
Would you add any additional reasons to avoid credit card debt?
Note that credit cards can be useful (see this post) so this blog isn’t about why you shouldn’t have a credit card. It can also be useful to carry some debt in general (a financial term called leverage), so this is also not a post about avoiding debt altogether.