 | Q: Do you see any credit traps I should avoid?
A: Yes. There are four main traps that seem to ensnare people today.
TRAP ONE: THE POTENTIAL OF GETTING TOO MUCH CREDIT. Ten short years ago the average person could get about $10,000 of credit on credit cards. Today that amount has more than quadrupled to over $40,000 of credit card access for a person with good credit! Salaries have not kept up with that increase, so the result is that people today can get more credit with less ability to repay it. (Read the section about ATTITUDES to see how destructive this can be).
TRAP TWO: THE PERSPECTIVE WE HAVE TOWARD CREDIT. Most people view credit cards like they are money! In reality we know that this is not the case, but in practice we use them like they were real money. I have a little jar of old credit cards that I take with me when I speak in high school classrooms. I ask the kids a question: “If there are 300 credit cards in this jar and each card has a $4000 credit limit, how much money is in the jar?” The standard answer I am given is $1,200,000. I then tell the kids, “Just think of how valuable this little jar is! You could reach in one hand and pull out a quarter million dollars! You could, that is, IF credit cards were money. But they are not money - Credit cards are debt! There is therefore, absolutely no money in the jar, but there is $1,200,000 of debt!” My goal is to get young people to have a proper perspective toward credit cards. I want them to see them as the ability to create debt! If I can accomplish this one objective, they will probably not get into trouble with them!
That means that each time we use our credit card it is similar to taking out a loan. It is more convenient to use the card and we do not have to ask anyone's permission, but we nonetheless have to pay the "debt" back with real money and with real interest charges!
TRAP THREE: THE PAYMENTS WE MAKE ON CREDIT DEBT. Most of us tend to focus only on the required monthly minimum payment. That can be a formula for disaster when it is applied to credit card usage. Credit cards require a very small monthly payment, plus the payment declines as the balance we owe declines. If your credit card balance is $2000, your minimum payment will be 2%, or $40, but when your balance is $1000, your payment will only be $20. This would not be a problem if we paid our credit card balance off every month, but over 60% of us do not! And those of us who do not will usually just pay the minimum payment requested. So what happens?
Well, let’s say you charge $1000 on your credit card for Christmas. You determine to pay it off faster than just minimum payments, so you keep the monthly payment a flat $20 until the debt is paid. It will take you nine years to pay off your Christmas debt, and it will cost you $800 in additional interest! That means that if you have kids in junior high school, you might still be paying for Christmas presents you bought them before they started elementary school! How many Christmas presents have you bought your kids that lasted nine years? Very few. So, most of the presents you buy for Christmas that are charged on your cards are long gone by the time they are paid for! Looking at it that way certainly takes the “Ho, ho, ho” out of Christmas credit card charging, doesn’t it?
Or let’s say you purchase a $3000 computer for your graduating high school senior. You want to help him pursue that career in journalism and determine you can afford such a gift. You estimate the payments will begin at $65 a month (2% of $3000), but will decline as the balance declines. Is this a good idea or a bad idea? Would it make a difference if I told you your son will be thirty-one-years-old when you make the last payment on his graduation computer? By that time, thirteen years to be exact, you will have paid an additional $2600 interest, making your $3000 computer actually cost $5600! The fact of the matter is that your son will have gotten rid of his obsolete computer long before it is thirteen years old, but you will not have finished paying for it yet! And that is the way it is with most of the things we charge on our credit cards; they are long gone by the time we pay for them.
Don't fall into the trap of paying your credit card balance off at the minimum payment. To do so will ensure that whatever you bought with your credit card will be worn out, broken, eaten, forgotten, given away, become obselete, or used up years before you actually pay for it!
TRAP FOUR: THE PRACTICE OF BORROWING TO PAY OFF CREDIT. There is a trend today to use credit to “pay off” credit. This can be done in a number of ways: (1) Borrowing against your retirement; (2) Taking out a personal consolidation loan; or (3) Taking out a home equity loan, often called a second mortgage. Although each method is a bit different, the principle is the same – “Borrow To Pay Off Debt”. Is this a good idea or a bad idea? Usually it is bad. We often see folks in our offices that have already gone this route to paying off their debt and have found it did not work. Why?
Borrowing to pay off debt does not really pay off anything – it creates more debt! An illusion is created because the credit card balances are zeroed out. It looks like the debt is gone, but it has simply been transferred to another place – the new loan. You do not have less debt; you have the same amount, or in many cases more debt! You say, “Yes, but the interest rate on the loan is less than it was on the credit card.” That may well be true, but read on.
Borrowing to pay off debt does not attack our main problem – our spending habits. Within 2 ˝ years, the credit card balances are once again as high as they were before the new loan was taken out. Since those balances were zero, we began to use the cards again, only sparingly at first, but soon back into full swing! If our spending habits are not altered, borrowing to pay off our debt will only get us into more debt.
Borrowing to pay off debt often turns an unsecured debt into a secured debt – and that is rarely good for us. I am aware that the home equity loan interest is lower and that it is often tax deductible. But that does not offset the fact that many place their only “nest egg” (their home) at risk by borrowing against it to pay off unsecured debt. If a default occurs, their home can be forfeited. And again, usually within 2 ˝ years the card balances are as high as they were before.
It is not that borrowing to pay off debt could never work; it is simply that is usually does not work! We always think we will be the exception to the rule, but normally we end up like the average statistic.
Let’s say you lived next door to me. You see me out in my front lawn Saturday morning digging a big hole and putting the dirt in a wheelbarrow. You say to me, “What are you doing?” I reply, “I need some dirt to fill in the big hole in my back yard, so I thought I would dig a hole out here to get it.” Now, you may not say out loud to me what you are thinking, but my guess is that you would put my IQ at about room temperature? After all, who in their right mind would dig a hole in order to be able to fill in another hole? My point is made. It doesn’t work. Someone said it this way: “You can’t borrow your way to prosperity”. Why is this? Because digging another hole to fill in a hole creates another hole, and this second hole always seems to be a little deeper than the one we are filling in. So, don’t be so focused on interest rates and tax deductions that you take the “quick fix” and try to borrow your way out of debt! It usually does not work.
(See the section of DEBT - Repayment).
Copyright © 2004. Jim Garnett
The above information should be understood to be a general discussion of the subject matter and DOES NOT constitute a legal opinion about the situation. For further information please consult a qualified attorney. .
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