With Black Friday having taken its toll on local malls across the continent and Cyber Monday upon us, many are hoping to knock off a few gifts from their Holiday shopping list. Welcome to peak season in retail. It is difficult to ignore some of the outrageous deals that our favorite stores now have for a limited time. However, this is also a common time to load-up the “deal-with-it-later” card, otherwise known as the credit card.
- Credit cards are attached with immensely high interest rates
- The effect of compounding actually increases interest payments
- A line-of-credit is a much cheaper source of debt
- Online shopping and “tapping the Visa” has made it significantly easier for us to detach ourselves from our spending habits
Credit cards are associated with absurdly high interest rates, usually greater than 18%. Thus, the importance of paying-off credit card balances every month cannot be understated. What makes this even more crucial is that the credit card quoted rates do not take into account the effects of compounding. The quoted rate, such as 19.99% is actually the Annual Percentage Rate (APR). An APR is essentially a rate that includes any additional fees associated with the debt but does not take into account compounding (Investopedia 2016). For example, if the monthly interest rate on your credit card is 1.67% then the APR is 12 x 1.67% which is approximately 20.04% (Investopedia 2016). This rate however does not consider the impact of carrying a balance on your credit card over to the next month.
There is a way to determine the interest rate paid on debt that experiences compound interest. It is called the Effective Annual Rate (EAR). The EAR formula is as follows:
Where n is the number of compounding periods, usually measured in months (Investopedia 2016). Now let’s take a look at what the EAR is for a quoted annual credit card rate of 19.99%:
Thus, when taking into consideration the effects of compounding the effective annual interest rate on the credit card is actually larger than the initially quoted rate at about 21.93%. This further emphasizes the importance of paying down credit card debt every month. It also shows that it is crucial to pay down credit card debt before investing money in the stock or bond markets as it is highly unlikely that anyone will earn a return greater than 22% for an extended period of time, if at all.
Other Debt Options
A line of credit (LOC) can be an excellent option for short term borrowing and costs significantly less than a credit card in terms of interest rates. LOC’s are available through banks. The best way to qualify for a LOC is through having a good credit score, and the best way to give yourself a good credit score is to always pay back your credit card on time – even when they are just small amounts. Your credit score will apply to any type of lending that you are trying to secure, including a mortgage, further enforcing the need to making paying-down credit card balances a top priority.
Ease of Spending
Credit card companies and online retailers are making it easier and easier to spend money online. Given the developments of “tap” and mobile payment features, it has come increasingly easier for one to detach themselves from their spending. According to David Chilton, author of The Wealthy Barber and The Wealthy Barber Returns, there is a neurological effect associated with pain recognition that occurs when we notice the price of a item which we are considering to purchase (Chilton 2011). Furthermore, George Loewenstein, a neuroeconomist at Carnegie Mellon University explains that, “with credit card it is also easier to miss, or deliberately ignore, how much one is spending” (Chilton 2011).
There are many sales that are attracting consumer attention at this time of year. Black Friday, Cyber Monday, and Boxing Day all present opportunities for consumers to take advantage of heavily discounted items. However, keep in mind the impact of compounding on credit card debt before “tapping” the Visa or clicking “add to cart”. Be sure to also contemplate your ability to repay the debt of any credit card purchase before your next credit card bill, as deferred payments via a credit card will actually increase the cost of that item.
Finally, and arguably most importantly, be conscious of your spending habits and do not let the availability of credit influence your spending. Any type of saving becomes drastically more difficult when facing the uphill battle of 18%+ interest rates from credit card debt.
Brandon Belding and Simon Tomlinson
Breaking the Trend
- Chilton, David. 2011. The Wealthy Barber Returns. Kitchener, Ontario, Canada: Financial Awareness Corporation.
- Investopedia. 2016. Annual Percentage Rate – APR. 11 27. Accessed 11 27, 2016. http://www.investopedia.com/terms/a/apr.asp.
- —. 2016. Effective Annual Interest Rate. 11 27. Accessed 11 27, 2016. http://www.investopedia.com/terms/e/effectiveinterest.asp.