Reprinted by permission of the authors, Kyle Prevost & Justin Bouchard, from More Money For Beer and Textbooks. Copyright©2013 by Young and Thrifty Publications.
If you have ever been to a post-secondary campus during the first two weeks of the fall semester, you’ve probably noticed the attractive displays and booths set up by credit-card distributors. Credit-card companies make oodles of money, and they can afford to hire some pretty smart people in their marketing departments. This usually results in clever little giveaways and freebies that entice impressionable young students into signing up for their product. A 2009 study found that nine out of 10 graduating university students now had at least one credit card each. Yet some financial “gurus” tell young people to avoid credit cards at all costs: “They’re evil!” they shout from their mountaintops of frugality.
We don’t belong in that group of “experts”. Much like any other tool, a credit card has perfectly valid uses and can fill a variety of needs for a student. At the same time, abusing a credit card can absolutely wreck your finances for many, many years to come. Credit cards are not the root of all financial evil, but financial illiteracy is–and the two put together can be disastrous.
To understand fully just how credit cards can throw you off your game so quickly, it is kind of important to understand how interest, especially compound interest, works. Yes, there is some math involved here, but don’t worry–we’re not math guys either, so we’ll keep it simple. Before we look at any numbers, it’s worth taking a peek at what a wise man once said about compound interest:
“The most powerful force in the universe is compound interest.”
The great thing about compound interest is that, when you start to invest, it’s going to work in your favour and it will help make many of you millionaires. (Because you’re going to graduate debt-free after reading this book, you’ll be on the right track.) The other side of the same coin is that compound interest is just as powerful when it works against you–which is what it does when you borrow money–and it creates a negative feedback cycle that can quickly drown you in debt.
Be Afraid . . . Be Very Afraid
Just so the powers that be are satisfied, we’ll illustrate the worst-case scenario that can result from irresponsible credit-card use, before we let you in on why you should get one anyway. When you borrow money on a credit card, the credit-card company charges you interest on the amount of money that you borrowed. (The amount you initially borrow is called the principal. For a refresher on the basic concept of interest, turn to page 69 and to the Glossary.) Let’s look at an example, and for this you’ll need to know that when you “carry a balance” you’re paying back less than the full amount you owe–each month, some money you borrowed more than a month ago still hasn’t been paid back. If your credit card has an annual interest rate of 19.99 per cent, and you carry a balance of $100 all year while paying back only the interest each month, you will have paid the credit card company roughly $20 in interest by the end of the year–on top of the original $100 you borrowed. When you use small amounts, like that $100, this doesn’t seem so bad–but this can snowball in a hurry. Carrying $1,000 for the year will cost you $200–and we’ve seen a few students graduate with $5,000 or more in credit-card debt, and it was costing them $1,000 and up, every year, just to pay the interest!
Even worse problems arise when you can’t even pay all your interest every month, let alone any of the principal. Most credit cards will let you pay a small monthly minimum payment, usually $10 or about three per cent of your balance, whichever one is larger. What happens at this point is that, if you can’t afford to pay back at least your interest, it gets tacked on to the principal you already owed and essentially becomes part of a newer, and larger, principal. This doesn’t just happen at the end of the year: it happens every month–when next month comes, the new interest you owed this month will be considered just the same as the original amount you borrowed, and they’ll charge you interest on the interest too. That is what they call compound interest, and it can sink you quickly. You’re paying for the privilege of borrowing money to pay for the privilege of borrowing money, to pay for the privilege of . . . you see the pattern–and it goes back as many months (or years) as it’s been since you first swiped your card to buy something, and lasts until you’ve finally paid every penny you owe, including all the interest, and get things back down to zero.Report Typo/Error
Follow us on Twitter: