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Cheers to a Debt-Free Holiday Season!

By: Investor Solutions

By: Investor Solutions, Inc.

My holiday present came early this year. Just this week, I received an unsolicited credit card offer from a credit card company. Even though I know better, my first reaction was that of excitement. Now I had more “money” to spend on holiday gifts for my family and friends. And then, of course, I read the fine print. You know, where it tells you the interest rate, 18.9%!

Americans are not only ringing in this holiday season with catchy holiday songs and eggnog: ‘tis the season for more credit card debt. This is the time of year when the credit card companies make a killing, throwing frenzied shoppers a “lifesaver” to help them get through the holiday (spending) season. But don’t give in to the temptation and spend the rest of the holiday season feeling less than jolly.

The Consumer Credit Counseling Services polled 588 respondents and found out the following:

  • 30% plan to spend between $300 and $500 this holiday season
  • More than 21% plan to spend $500 to $1,000 this year
  • Almost 5% of the respondents will spend more than $1,000

They also found that 43% of the respondents are still paying off last year’s debt and 30% were paying off the previous year’s debt at this time last year. The numbers speak for themselves. Credit will be crucial during the holiday season and most debts won’t be honored immediately (although we all promise ourselves to do so). In fact, only 35% of credit card holders pay off their balance each month.

It’s no secret that credit card debt is expensive. That’s because the interest charged on these liabilities is compounded. Simply stated, compound interest is interest computed by applying an interest rate to the sum of the original amount and the interest credited to it in early time periods. The longer the repayment period, the larger the principal grows and the more the debtor will pay in interest. A purchase may cost double or triple (if not more) its initial value if the credit card holder is not careful.

For example, John charges a $1,000 worth of gifts for his children. The interest rate on his card is 18.9%. John is not a disciplined consumer and come January of the following year, only makes the minimum payments each month ($40). At this rate, it will take a little under twenty-two years for John to pay off his card assuming he makes no other purchases on this card. The total interest paid is $560, more than half the original purchase value.

Let’s assume, instead, that John pays off his card in six months by increasing his payment to $180. In this scenario, his total interest paid is $55, ten times less than he would have paid if he delayed payment.

I realize that a $500 savings may not seem like much, but that is just on one purchase. What if in subsequent years, little Johnny’s holiday gifts are charged to a credit card?

Period

Balance

Interest Rate

Payment

Total Payment

Interest Charge

First Holiday Season

$1,000

18.90%

$40

$1,557

$557

Second Holiday Season

$2,000

18.90%

$80

$3,207

$1,207

Third Holiday Season

$3,000

18.90%

$120

$4,856

$1,856

Fourth Holiday Season

$4,000

18.90%

$160

$6,506

$2,506

Fifth Holiday Season

$5,000

18.90%

$200

$8,155

$3,155

Let’s assume now that John, fed up with his credit card debt, makes a new year’s resolution to pay off his $5,000 balance in one year instead of in twelve years as he would have if he only made the minimum monthly payments. His monthly payments will be a whopping $460 a month. His interest paid for that period will be $527.

Furthermore, once he has paid off the credit card, he saves and invests the $200/month he would have paid to the lender into a balanced, moderately risky portfolio earning an average annual rate of return of 8% (note that this 8% is also compounded interest). In twelve years, his investment will have grown to $48,000.

John got wise to the financial suicide that delaying payment of his credit card can be, and instead went with option two and paid off his credit card in one year. Twelve years from now he will be $48,000 richer. The lesson learned from John is that a credit card is a great way to extend your purchasing power in times of real financial need or simply during the holidays assuming that you pay it off immediately. That’s because the interest charged on these cards far exceeds the return potentials of any other investment available today.

Carrying credit card debt for too long spells financial disaster. So, give yourself the gift of financial freedom this year and pay off those credit cards.